Airline capacity change vs. 2019 and load factor, January-September 2020
From a planning perspective, airlines exposed to connecting, long-haul, and premium demand are likely to be the most heavily impacted owing to the more prolonged recovery profiles anticipated for these segments. Imagine the challenges of rebuilding a network where over 60% of traffic connects. How does an airline restore this connectivity with a reduced service offering in the face of numerous travel restrictions?
Contrast this to the business model for low cost point-to-point operators focusing on the leisure and “visiting friends and relatives” (VFR) segments. Rebuilding these networks during summer—normally a peak season for travel when demand exceeds supply—is comparatively much simpler.
A closer look at traffic performance of major ultra low-cost carriers (ULCC) and full-service network carriers confirms these challenges, and reveals the following key trends:
- ULCCs can leverage the crisis to strengthen their position. ULCCs have capitalized on their very lean and highly variable cost structures, focus on VFR and leisure traffic, point-to-point demand, and primarily domestic/regional networks to ramp up quickly. Full-service network carriers, meanwhile, struggle with higher fixed costs and a reliance on international and long-haul service, corporate travel, and on hundreds of non-existent connecting flows to fill seats.
- The initial months of restart are the hardest. Airlines often must start filling flights from scratch. However, as airline planners and revenue management teams get a better handle on the situation, loads can return to pre-crisis levels in a matter of months (yields is a different story, although we only have anecdotal evidence to suggest that revenue will take much longer to recover than demand).
- Airlines cannot plan more than a few weeks ahead. Europe is a prime example, as the strong surge in demand over the summer stumbled as rising cases in the fall forced renewed travel restrictions. Airlines and customers need to remain flexible.
- Tactical network decisions replace traditional strategy. In a bid to follow the demand, full service network carriers are adding new non-hub point-to-points routes to capture the little demand that does exist, breaking with the previous strategy of anchoring routes to a hub or focus city. Hence, routes that were previously unimaginable for a given airline are now possible.
In Europe during the peak summer month of August, Wizz Air’s capacity was only -20% vs. prior year. Ryanair had a similar albeit not as aggressive ramp-up. They reached a low 70% load factor, well below pre-crisis levels, but sufficient to cover cash costs. Meanwhile, full-service carriers like Lufthansa or Swiss were stuck at -70% vs. 2019 capacity with load below 50%, which are unsustainable levels. However, since then, a surge in COVID-19 cases have led to renewed lockdowns and a sharp drop in capacity for ULCCs and network carriers alike.
Select European airline capacity change vs. 2019 and load factor, January-September 2020
In Latin America, Volaris (a ULCC) is among the best-performing airlines in the world right now, with ASKs down only 16% in September and high 70% load factors. Management predicts a return to pre-pandemic capacity by year-end. Volaris is capitalizing on the virtual exit of Interjet and restructuring of Aeromexico to gain market share and expand into a previously saturated Mexico City International Airport.
GOL, a “hybrid” low cost carrier, has only increased capacity to -60% of pre-pandemic levels, but stands out for maintaining high load factors in the 80% range—a feat that few carriers are achieving as they struggle to align supply to demand. Meanwhile, network carriers like Aeromexico and LATAM, both undergoing restructuring in Chapter 11, are adding back capacity very slowly, and yet their load factors are below 70%, far below pre-crisis levels.
Select Latin American airline capacity change vs. 2019 and load factor, January-September 2020
In the U.S., full service network carriers have departed from their traditional network planning strategy, whereby new routes are anchored to a hub or focus city and drive connecting traffic, and have added new point-to-point routes in a tactical move to chase traffic. United and American have introduced 29 and 13 new point-to-point routes, respectively, catering exclusively to leisure demand. Florida and Mexico are the main beneficiaries.
New point-to-point routes for United Airlines and American Airlines, December 2020
Source: IATA AirportIS
A new dilemma for network planning: minimizing cash burn
The decision to fly or not fly a given flight has traditionally been determined during the network planning stages, months before departure. For all intents and purposes, only routes and flights that at least cover their variable costs are kept in the schedule, while those that do not are weeded out during the schedule planning process. While some capacity fine-tuning does occur closer to departure, including aircraft assignment and swaps, these adjustments are usually due to resolve operational issues, and not to optimize financial performance. This is because most airline costs are fixed as demand draws near, and the threshold to cover the variable cost of a flight is quite low, generally requiring a low variable break-even load factor (see figure below). Hence, close to departure, decision-making is largely in the hands of Operations.
COVID-19 changes this, as the pressure to conserve cash is so great while passenger demand is so unpredictable. To face this situation, airlines have negotiated concessions from their workforce and suppliers to minimize cash burn. In an industry in which much of the cost structure is fixed or semi-fixed, this has not been easy. However, as both labor and suppliers recognize the existential crisis the airlines are facing, airlines have obtained an unprecedented level of concessions, including converting monthly aircraft lease payments into power-by-the-hour agreements in which airlines only pay lease and maintenance reserves when they fly the aircraft. In many instances, they’ve reached similar arrangements with flight and cabin crews. This has allowed full-service network carriers to variabilize up to 80-90% of their cost structure versus a typical ratio of 60% fixed / 40% variable.
Representative full-service network airline cost structure, pre- and post-COVID-19
While this is a welcome relief for airlines, it creates a new challenge: the threshold to fly or not fly any given flight is now higher than ever. Prior to COVID-19, airline planners rarely had to worry about flights scheduled for the coming months covering their variable costs since the load factor required to cover such costs was quite low. As airlines have pushed more costs from fixed to variable, this has raised the variable break-even load factor. Our estimation is that the variable cost break-even load factor for full-service network carriers has increased from 40-50% load factor to 70-75% load factor, assuming pre-COVID-19 average fares. With the lower average fares carriers are currently experiencing, variable break load factor may be 10-15 percentage points higher.
Hence, if in the past, a flight with a 50% load factor covered its variable costs and contributed to fixed costs (by the time departure approached, it was too late for an airline to do anything about the fixed and semi-fixed costs anyway), the variable break-even load factor is now upward of 70%. Airlines must weigh the tradeoffs of operating relatively full flights at a cash loss versus the reputational risk of increased flight cancelations and greater schedule uncertainty.
Variable cost break-even load factor, highly fixed vs. highly variable cost structure
Considering the low load factors and depressed yields that airlines globally are achieving as they add back capacity, this shows the challenge that airline planners are up against as they need to weigh the cash flow impact of every flight they add. In the past, network planning built the schedule, passed it onto revenue management/pricing to optimize inventory and pricing, and finally to operations to deliver the schedule. And then at that point performance was assessed to fine-tune the future schedule. The new COVID-19 reality calls for much tighter coordination among these three groups. They must now work together unlike ever before, fine-tuning the schedule in real time to avoid cash-losing flights while minimizing disruption to passengers and crew.
An uncertain winter awaits
As winter approaches in the Northern Hemisphere, the capacity ramp-up observed over the summer is receding. Meanwhile, in the Southern Hemisphere, airlines are ramping up for the coming peak season. However, due to the uncertainty over travel restrictions, booking curves have shortened and passengers are demanding flexibility. Hence, airline planners will continue to face a recovery period of unpredictable demand and heightened financial risk that will last well into 2021.
These conditions will be particularly challenging for full-service network carriers, who will continue to struggle to recover traffic and to push up yields but will create opportunities for ULCCs who have the financial means and risk appetite to seize them. The pandemic will accelerate the shift in industry structure in favor of the most efficient airlines (ultra-low cost and “hybrids”), who will recover sooner, emerging stronger and with an improved market positioning. It will also push full-service carriers to evolve away from a strict focus on hub-and-spoke networks, and embrace more point-to-point flying, further blurring the divide between full service versus low cost business models.
From an organizational perspective, carriers require a high degree of integration and coordination among planning and operations to conserve cash as capacity ramps up. This is particularly true as carriers add back new routes and become familiar with what demand looks like in the new environment, since historic performance prior to COVID-19 is no longer relevant.