Deregulation Countdown – Australia

“To casual observers, deregulation generally means one thing – lower air fares. But for the airlines and others associated closely with this industry, deregulation is a far more complicated issue, which demands a mix of sophisticated strategies and quick thinking . . . Deregulation means freedom. It gives us the freedom to introduce competitive measuresas and when we see the need. “

John Schaap, MD & CEO, Australian Airlines

“Deregulation means market based prices and the elimination of cross-subsidies created by the regulated environment- it is about everybody being able to expand where it is economic to do so. In the short term the business will be high risk for all operators.

From November on, we are not the railways!”

Sir Peter Abeles, Joint Mng Dir, AnsettTransport Industries

• • •

Don’t listen to anyone who purports to predict what Australia’s aviation system will look like five years from now. There’s just too much uncertainty to have any real chance of being right. Never before has Australia’s aviation system been so unpredictable. For example:

• We are facing the severest economic recession for 20 years (which may well become worldwide);

• The decision has finally been taken to privatise Australian Airlines and Qantas, a decision which will substantially alter the nature of these airlines and will probably have an influence on Australian Government policy. Purchases by and alliances with foreign airlines will add a new dimension to Australia’s domestic and international operations;

• The Closer Economic Relationship (CEA). Although the reduction of restrictions on trade between Australia and New Zealand is progressing more slowly than many would have hoped, a single aviation market looks increasingly likely; failing that, there will undoubtedly be some changes in the aviation balance, particularly given the dual presence of Ansett in both the Australian and New Zealand markets;

• Tourism. ‘This is a wild card in any projections on Australian air transport growth. The official projection of 3% annual growth domestically for the next decade must seem low given the potential for stimulation of the market by discounting; the international inbound tourist market will be influenced by a vast range of factors including the level of the Australian dollar, the marketing effort put• Tourism. ‘This is a wild card in any projections on Australian air transport growth. The official projection of 3% annual growth domestically for the next decade must seem low given the potential for stimulation of the market by discounting; the international inbound tourist market will be influenced by a vast range of factors including the level of the Australian dollar, the marketing effort put in by the Australian Government and others, the world political situation, the ability of Canberra to put together a workable infrastructure development program, and so on;

• Potential new airline entrants, particularly in view of the potential for foreign investment which appears to be a new window created by the exigencies of the privatisation debate;

• The near certainty that Qantas, in one form or another, will enter the domestic market during this time – if for no other reason than that it is illogical to talk about joining the mega carrier league while at the same time voluntarily holding one arm behind your back. Add all these different factors together and the sum is a bewildering set of possibilities. Only the bold and foolish would predict the outcome.

Short Term Fireworks

But in the short term, anyone who thinks that deregulation won’t have an impact is out of touch with economic developments. All the signs are that there will be a flurry of pricing activity. Quite simply, there’s going to be too much capacity and not enough demand to continue along the highly cocooned tracks which have been followed up to now. Interestingly enough, the US, when it deregulated in 1978, was also entering a period of recession – although not as severe as the present one looks like being – as well as a period of high fuel cost. There, the result was a rash of low fare initiatives as carriers rapidly expanded onto new routes and fought for market share. There are many differences also. With the exception of Compass, the carriers involved are already operating most of the routes that they want to operate and the capability of yield management with the sophisticated computer reservation systems now available will at least mean that the pricing strategies are more sophisticated.

The name of the game is going to be market share, cashflow and cost reduction. Until now, except for some relatively modest sparring over one or two percentage points of market share, the majors have not taken the gloves off. Furthermore, cashflow was not generally a major issue. Each carrier had a more or less guaranteed existence and any substantial imbalance would be prevented by governmental intervention. Now, with the prospect of a privatised Australian Airlines and Ansett and Eastwest which also have to respond to prevailing economic conditions, cashflow is going to become a dominant airline objective in Australia as it is in other countries. And each airline will be looking for increasingly more cost effective measures at all levels.

In brief, this means that there will be significant pricing initiatives in the next year at least. It suggests also that, even if we do end up with an unregulated duopoly in place of the existing regulated duopoly, the new two headed beast will be vastly different from the old one. The Australian market is certainly not big enough to support more than two nationwide airlines – and in fact may not, in a competitive environment, be big enough to accommodate more than one. Don’t forget that the Airline Policy was introduced in the first place to prevent a monopoly (byTA A!). The support of foreign airlines – through equity and alliances as a result of the Qantas and Australian Airlines privatisation – may well provide a valuable substitute for the old policy.

Discount Fares for Everybody

Australia’s domestic market has next to no. . experience with price and demand elasticity. The nearest we come to predicting the likely impact of substantially lower fares in generating tourist traffic domestically is to look at the recent holiday behaviour of Australians when confronted with the option of a domestic airline and ground package compared with international packages like $500 for a week in Fiji or Vanuatu, or $900 for a week in Hawaii. Until now, bargains of this type would have been unthinkable in the Australian market.

In fact it was decidedly not in the interests of either of the major carriers to encourage this type of thinking. The prevailing risk of diverting capacity away from full fare passengers to this type of low yield, high volume traffic was just not necessary in the regulated environment-in fact, it would have been bad management. But it is clear that Australian, Ansett and Eastwest are alert to the potentials of innovative low fares on stimulating the market and they have already positioned themselves accordingly.

The Business Traveller

Business travellers and ‘must go’ passengers are only mar- ginally susceptible to discount fares. Therefore, it is improbable that these sectors of the market will see substantial discounting. In fact it has been the experience in the United States and Canada that full fare economy and business prices have actually increased faster than the CPI. From a pricing policy point of view, discounting of these fares is a high risk strategy. These are the passengers who provide the highest yield and to tamper with the possibility of bloody competition for market share in this area is to threaten the very value of the traffic itself.

To date, the response has therefore been brand loyalty moves like ‘Frequent Flyer Programs’. Frequent Flyer Programs are a pro- cess by which airlines mortgage their future by giving passengers who pay full business fares the right to a specified number of air miles in the future. Initially, these were very attractive to business travellers, because they could use the air miles so gained for personal travel. Therefore the airlines were actually targeting the individual business traveller to persuade him personally to make a decision which carrier to fly with, ie they were actually finding the price-sensitive element of this traffic. The programs create a brand loyalty, as the traveller tries to accumulate higher and higher mile-age entitlement with the same airline.

Along the way though, a number of things happened. First of all, of course, each of the airlines did it, thereby removing the competitive edge at the same time as effectively making it essential for each of the carriers to mortgage their future in this way. (In some cases in the US it has led to ridiculous accumulations of future travel commitments by some of the major carriers. ) Another development was that employers in many cases began to insist that the route miles accumulated should benefit not the individual passenger, but should be credited to the company paying for the travel in the first place.

Thus Frequent Flyer Programs are not a matter of whether, but of when. Given the prevailing economic situation and the weak business market, it would be surprising if we had too long to see them in the Australian marketplace. Interestingly, at that stage, the alliances of the respective carriers will become very important, because if the free miles inducements can be extended to world-wide route networks or alliance partners, then the attraction becomes that much greater.

The bad news for Australian business travellers is that they can be certain that Mr Boucher will have his eye on this type of inducement if it does in fact become widespread. Treating free miles as taxable income in the hands of the business traveller would make these programs much less attractive for the Australian domestics. They would then be obliged to look for alternative means of guar- anteeing their market shares.

As Australian airlines already offer the highest levels of on-ground and inflight service in the world, market share is unlikely to be greatly enhanced by so called service competition. Presum- ably at this stage, the airlines will rely much more heavily on corporate discounts, so that the major companies are able to negotiate better one-on-one exclusive, or nearly exclusive, deals with the airlines involved. There are of course other ways of attracting travellers; one of the better publicised extreme examples was the carrier in the United States a few years ago which provided free air transportation for anybody buying a particular brand of camera! Another way, certain to be followed, is be selective (usually vol- ume related) commission incentives for agents. The days of fixed 5% commissions for agents are behind us as the airlines will be seeking to attract customers at the retail level, by encouraging agents to ticket their way.

Discount Fares for Tourists

So, while the prospects for business and first class travellers are not for directly lower fares, the situation in the price sensitive part of the market is vastly different. Every seat on an aircraft is a perishable commodity which ceases to have value as soon as the aircraft doors are closed. Thus, to the extent possible, it is vital for the airline to seek to fill as many seats as possible so long as it covers marginal costs. Also, increased utilisation can greatly increase revenues and we can expect to see more operations like the Australian Airlines 2am flights from Melbourne to Cairns at substantial discounts- although curfews at Sydney and other airports will limit this capability.

Except for expensive tourism packages to the up-market resorts owned by Australian and Ansett, Australians are not familiar with low priced tour packages domestically. Charter packages, whether they are on scheduled services or on fully dedicated charter operations, are likely to become a new feature in the Australian market.

The depressed tourism industry is gradually recognising that high volume tourism discounts are going to be necessary if they are to remain in business. Until now tourism facilities have tended to market individually, with only occasional large scale intervention by the tour wholesalers.

The wholesalers appear to have focussed on international markets because they were more attractive given the combination of cheap international fares and the very low on-ground fares available in places like Hawaii.

This must change as the domestic market opens up and, miraculously, we shall be seeing seven day, all accommodation included, packages being retailed at half the price of what until a year or two ago was the lowest available economy fare. This could give an enormous boost to domestic tourism, as well as assist our balance of payments problem by tending to keep Australian travellers onshore and lowering the infrastructure cost base for inbound tourism.

The advent of discount fares also means that the average passenger is going to have to become much cleverer, as is the average agent. Rather than phoning up and buying the full economy fare or selecting from a handful of heavily conditioned discount fares, passengers will now need to shop around to get some of the cheaper discounts which will be available in the marketplace. Instead of the previous handful of discounts, we can expect hundreds – even thousands – most of them capacity limited, or off-peak but generally free of other conditions. This will put pressure on agents to make full use of the automated facilities now becoming available if they are to handle this type of enquiry.

Industry followers will recall that in fact Compass has promised across the board discounts (from existing economy fare levels). Earlier this year they were talking of fare cuts of 20% on standard rates and 50% on off peak. As Chief Executive Bryan Grey said: “There wasn’t a lot of research done into the size of the cuts. We just knew what sort of fares we needed to offer to attract passengers and what we could afford to offer and, I suppose, we had to offer a discount that the other two airlines would find impossible to match. “” Compass estimated that a 20% fare reduction from existing lev- els could generate market growth of 1. 7m passengers per annum, theoretically permitting Compass to gain a 15% market share with new passengers alone. Relying on the reputedly greater cost efficiency of his operation, Mr Grey maintained that the competition would not be able to reduce standard economy fares by more than 6% without running a loss.

Experience in deregulated markets suggests however that simple, across the board tariff reductions are not a long term strategy. nor are single service operations (unless they are high volume, low yield charter services). Conventional wisdom is that (a) a selective pricing strategy is required, making full use of current yield management capabilities, and (b) a full range of services is necessary in order to derive the different varieties of cross-subsidy between low yield high volume discount traffic and higher yield but lower volume business traffic.

It will certainly be in this area that the Trade Practices Commission is going to have its work cut out to determine what is beneficially competitive and what is destructive.

All this doesn’t mean that a well run airline won’t still make money. Certainly both Australian and Ansett (as well as Eastwest) are well placed to stimulate substantial growth, as is Compass. Even given the fact that we’re in economic recession, the projected growth level of 3% for domestic services looks remarkably low. To some extent though this will depend upon how much capacity is added to the system. The pilots’ dispute made us well aware that there is a great deal of available capacity around the world which can be brought in at short notice. For example, a num-ber of the high volume UK tour operators are presently in financial difficulties and it may be that attractive rates can be achieved for importing some of these aircraft for short term operations in the Australian market. This is an attractive option so long as yields remain reasonably high.

Another factor which would increase capacity in the marketplace is higher and more effective utilisation of the existing equipment {now easier since removal of many of the pilots’ restrictive work practices). Options include better use of the off peak times available at non curfew airports, or simply reconfiguring existing aircraft tohigherdensity seating-another inevitability in due course.

Assuming sensible yield management which is now possible, the growth potential could well be turned into significant profit, albeit on lower margins. But yield management is no substitute for good management and large amounts of this will be needed. Here, we may be in luck. There’s a great deal of depth in airline management in Australia and it has the benefit of massive documentation of the mistakes and victories of others in other countries to draw from.

Potential New Entrants

The majors are covering most of the main price discounting options which Compass has available. But Bryan Grey must have been aware that this would occur. There is no quarter given in the free market. The difficulty for Compass is that it will be marketing much the same product as the competition – large widely-bodied jets with high capital overheads. As Grey says, he has the advantage of a single type fleet, so that he will gain the cost benefits of standardisation. This certainly carries a number of advantages but whether it will be enough to offset the great market power of the opposition is questionable.

After all, the economies of scale of airline operations are achieved with only a small number of aircraft and routes; mega carriers are mega so that they have greater market power, not to be more cost effective. If you don’t have market power you must have a greatly more efficient operation (Compass’ is not greatly more, just more), or you must find a ‘niche’.

But, that said, Bryan Grey is a survivor. He and other potential entrants will for example be watching with great interest the courting of Australian Airlines and Qantas by foreign airlines, now that the political decision to privatise has been taken – and the consequent slackening ofFIRS guidelines to permit the foreign carriers to purchase. While the initial Compass float did not attract much institutional interest (around 20%), a foreign group or airline could well see a significant share in Compass as being very attractive next year- even Air New Zealand for example,or perhaps an Indonesian carrier. But one way or another, the odds would have to be against more than two long term conventional airlines in Australia.

NEXT ISSUE: We conclude our analysis of the possible effects of deregulating the Australian domestic airline environment with a particular emphasis on examining the wide range of pseudo regulators which will in effect serve as their own regulatory authorities. Don’t miss it!