Air Asia Strategic Analysis

STRATEGIC ANALYSIS OF

AIRASIA THE BEST LOW-COST CARRIER AIRLINES IN THE WORLD

ASSIGNMENT FOR MICROECONOMICS FACULTY OF ECONOMICS AND BUSINESS NATIONAL UNIVERSITY OF MALAYSIA

BY: IWAN BUDHIARTA P-46048

MALAYSIA – 2009

I.

INTRODUCTION 1

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

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a single type of airplane (reducing training and servicing costs)

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a simple fare scheme (typically fares increase as the plane fills up, which rewards early reservations)

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free seating (which encourages passengers to board early)

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direct, point to point flights with no transfers

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flying to cheaper, less congested secondary airports

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short flights and fast turnaround times (allowing maximum utilization of planes)

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"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 2

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 simpleboarding 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.

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Dato’ Sri Tony Fernandes: We fly to where others dare not fly or have given up. “Being an unproven model, the low-cost, long-haul business is rather risky. But it is a feasible business with tremendous growth opportunities, hence it qualifies for us to put our money on it,” Fernandes explains. Fernandes and a group of individual investors, including Datuk Kamaruddin Meranun and Datuk Seri Kalimullah Hassan, collectively hold a 48% stake in AirAsia X. The other prominent shareholders in AirAsia X include British billionaire Richard Branson’s Virgin Group, with a 16% stake; Japanese conglomerate ORIX Corp with 10%; and Bahrainbased Manara Infrastructure Fund with 10%. AirAsia holds the remaining 16% stake.

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Management Strategy AirAsia’s goal is to establish itself as a leading low-cost carrier in Asia. The principle components of AirAsia’s strategy are as follows: Maximize Shareholders’ Value • Profit creation by expanding business reach within Asia • Expand routes and network via a prudent calculated manner • Invest and enhance brand - raising investors' returns

Focus On Customers’ Needs • Stimulate demand by offering the lowest fares • Comprehensive distribution channel • Develop various products and services while maintaining simplicity

Operational Excellence • All staff are contributors – no ranks or hierarchy • Continuous cost management • Performance based remunerations and incentives

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Strategic Direction Stage 5 Become a multi specialist • Yield maximization for matured routes • Significant ancillary composition Stage 4 Pursue regional market domination. Optimise routes and development of new secondary hubs • Further enhance route network, venture destinations previously uncovered • Yield enhancement due to benefits of maturity • Ancillary expansion Stage 3 (we are here) Pursue regional expansion & expanding business on existing platform (ancillary) • Expand network to new countries • Develop strategic partnership for mutual benefits • Use strong brand to drive new business Stage 2 IPO Capital Raising and become publicly traded company • Strengthen financial sheets • Improve company credibility & rating • Ability to negotiate favourable terms with our suppliers Stage 1 Entry to market. Aggressive brand building & recognition • Introduction to the market • Focus on market penetration • Induce first time flyers & open up new market

II.

Opportunities for Malaysian Aviation Industry

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“Air transport has brought enormous and positive developments to Malaysia. Following international principles with a focus on cost efficiency will help air transport play its role as a catalyst for economic activity even amid the enormous crisis in the global economy. Efficient air transport improves business competitiveness and supports tourism,” said Giovanni Bisignani, Director General and CEO of the International Air Transport Association (IATA). There are three priorities that I can identified as a success factors: 1. Efficient infrastructure: Malaysia’s bold move to reduce landing fees at Kuala Lumpur

International Airport (KLIA) by 50% for two years will keep KLIA competitive, supporting Malaysian tourism and international business. It demonstrates a clear understanding by the government and Malaysia Airports Holdings Berhad that competitive costs drive traffic and fuel economic activity. The priority must be on providing efficient infrastructure that delivers low costs for all airlines. Crosssubsidisation is not acceptable. Common facilities and services, such as landing charges and security, must be borne equally. And access to all facilities must be open to all airlines. 2. Environment: IATA’s Four Pillar Strategy of technology investment, efficient

infrastructure, effective operations and positive economic measures is delivering results. In 2009 aviation’s carbon footprint will shrink by 4.5%. Of this, 2.5% derives from capacity reductions. The remaining 2% is a direct result of efficiency gains with the Four Pillar Strategy. Each landing with a continuous descent approach has the potential to save between 160kg and 480 kg of carbon through reduced fuel burn. That is good news for the environment and helps reduce the fuel bill. 3. Commercial freedoms: Airlines cannot take advantage of commercial freedoms that

other businesses take for granted. Markets are closed until governments negotiate them open, and foreign ownership restrictions have resulted in a hyper-fragmented industry of 3,200 players that is vulnerable to economic shocks. Airlines facilitated the global village. Because of outdated rules, we are the last to be able to take advantage. This crisis must be an opportunity to modernised.

III.

Sustainable Growth of AIRAsia

Six and a half years of flying, continuing growth and profits in every quarter since day one. And Malaysia’s AirAsia is now claiming something more: it says it has the highest profit 8

margin of any airline in the world. AirAsia came out tops in our finance category this year for “delivering outstanding financial results and industry-leading profit margins while bringing low-fare airline serice to Southeast Asia and now, through AirAsia X, to the long-haul marketplace”. "Six years ago, we began as a small airline with a RM40 million debt and two aircraft. We have successfully turned the business around and had the most profound impact on the aviation industry. True to form, we must believe that our achievements today add up to just another beginning. We cannot rest on our laurels. The sky is high enough and wide enough to accommodate our growth plans. It is up to us to rise to the occasion." “When we first started, many people thought it was a crazy idea to offer low fares as it was not economically viable,” says group chief executive Tony Fernandes. “Especially with an airline with high aspirations like us, we were expected to fail. However, with strong persistence and the right strategies, we persevered and we are now the leading and largest low-cost carrier in Asia.” The numbers tell a solid story. In the first quarter, revenues increased nearly one-third to 535.1 million ringgit ($167 million) and net profit soared to 161.2 million ringgit from 86.8 million ringgit. AirAsia claimed an operating margin of 24% and a net profit margin of 30% during the period. Margins were even stronger in 2007, with its full-year operating margin coming in at 35% and a net margin at 36%. AirAsia’s revenues reached $450 million in 2007. AirAsia has also won long-running battles for more access under key bilateral air services agreements. The Singapore-Malaysia market, for example, which for decades has remained one of the most restrictive in Asia, finally opened up slightly earlier this year and AirAsia is now flying on the lucrative Singapore-Kuala Lumpur route. There is more to come at the end of this year when Association of Southeast Asian Nations members remove all restrictions on air services between capital cities. AirAsia has quite simply established itself as the largest and most profitable low-cost airline group in Asia, and despite new challenges amid high fuel prices, regional head of finance Rozman Bin Omar says: “There will always be demand for air travel whatever the fuel price is. With very affordable low-fare offerings, people will trade down.” He adds that “we expect to enjoy high profit margins in years to come”. 9

IV.

The Strategies: INCREASING FLIGHTS, ADDING ROUTES, BOOSTING CAPITAL AMID RISING FUEL PRICES

AirAsia has once again delivered profit growth for the quarter, despite operating in a very difficult economic environment characterised by record fuel prices, according to Tony Fernandes, Group chief executive officer. "This is our 23rd consecutive profitable quarter. This result shows the maturity of our marketing strategy whereby we are able to turn the 10

traditionally weakest quarter and deliver strong results. Our new routes have performed beyond expectations, with the Kuala Lumpur-Shenzhen route proving to be the best ever in the airline's history, "said Fernandes through a statement.

Budget carrier AirAsia is increasing flights, adding routes and boosting capital investments, as Europe's Ryanair Holdings (NASDAQ: RYAAY) and Southwest Airlines Co. (NYSE: LUV) have cut capacity this year due to soaring fuel prices. Last month, AirAsia gave away a million free seats, although passengers still had to pay taxes and fuel surcharges. The seven-year-old company said that it is aiming to fill the vacuum as other airlines reduce capacity, betting that more travelers will opt for budget flights amid a global economic downturn. The strategy could backfire. Revenue for the quarter was RM462 million (Ringgit Malaysia) in 2007, a growth of 39% compared to the same period last year. These results come on the back of 25% growth in passenger volumes, driven by a 10% higher average ticket prices and a 54% growth in ancillary income. Capacity grew by 34% for the period and load factor was constant to last year's 79%. ''Despite oil prices breaking new records, our cost improvement initiatives and the stronger Ringgit Malaysia against the US dollar has retained our position as the lowest cost airline in the world. The combination of higher yields with lower cost has boosted our profits significantly. Net income for the period was at RM180 million, a 157% growth against last year's net income of RM70 million,'' added Tony Fernandes. Last month, AirAsia posted a 95 percent plunge in its net profit for April-June quarter to $2.9 million. The company attributed that mainly to a $23 million foreign exchange loss from a weakened Malaysian ringgit, not weakness in its underlying business. Average load factor -- the percentage of seats taken up in an airplane -- dipped to a still relatively strong 76 percent, from 80 percent in 2007. The company said that it has a cash reserve of about $303 million but outstanding debts stand at $1.6 billion, giving it a net debt position $1.3 billion. Debts are set to grow as it receives new planes. The carrier has firm orders for 175 Airbus A320 planes, to be delivered gradually up to 2014, as part of fleet replacement and expansion.

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Chris Eng, analyst with OSK Securities in Malaysia, said AirAsia's growth prospects may be curbed while its joint-ventures in Thailand and Indonesia are expected to remain in the red. "It will be challenging but we believe AirAsia can survive," Eng said, citing its efficient regional network and good cost control. As it expands, AirAsia also faces a challenge in filling up capacity as consumer spending slows and competition increases from flag carrier Malaysia Airlines, which recently offered zero fares on surplus seats, analysts say. "Everybody is now having to dig deeper into the well of consumer demand and the more they compete, the more fares go down," said Peter Harbison, executive chairman of the Center for Asia-Pacific Aviation in Sydney. The International Air Transport Association has forecast a $5.2 billion loss this year for the global airline industry. It said crude oil price, currently averaging $113 a barrel, is still 55 percent higher than the 2007 average price while passenger demand growth is slowing even in Asia-Pacific. Fuel prices account for half of AirAsia's cost.

V.

AIRAsia Received PIKOM ICT Leadership Awards

PIKOM, the National ICT Association of Malaysia, honoured two organizations and two individuals at the PIKOM ICT Leaderships Awards 2008 at its Annual Dinner today. AirAsia Bhd received the PIKOM ICT Organisation Excellence Award. The awards were presented by the Minister of Science, Technology and Innovation Datuk Dr Maximus Johnity Ongkili at the PIKOM Annual Dinner 2008 in Petaling Jaya. Receiving the awards were Dato’ Sri Tony Fernandes (for AirAsia Bhd). PIKOM introduces the PIKOM ICT Leadership Awards, which

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is intended to honour and give due recognition to outstanding leaders in the ICT industry and user community. Prior to this, PIKOM has been organizing the PIKOM-Computimes ICT Awards since 1989 (later evolved to PIKOM National ICT Awards) to honour outstanding Malaysian ICT companies, products and individuals in the field of ICT for their contribution to the industry and society. For the category of PIKOM ICT Organisation Excellence Award, the recipient must be an outstanding organisation that have successfully utilised ICT to run the operation of its organisation effectively and created an environment that accelerates the all pervasive use of ICT across all segments of the community. AirAsia certain fulfills the criteria. The success of AirAsia as the region’s leading budget airline is reflected not only in its fast growing passenger volume but also from the ICT perspective. It is very successful in the use of ICT as a core business model, and it casts a major influence over all segments of society in creating a compelling reason for the use of Internet booking and e-Commerce. AirAsia has, almost literally overnight in corporate terms, demonstrated the strategic value of ICT to increase the competitiveness of businesses, promoted online booking, and helped dispel the myth that people are afraid to shop online because of network security fears.

VI.

AirAsia uses fuel-hedging instrument for minimizing a currency risk

AirAsia stated it has ‘never speculated on fuel prices in the past and will not speculate on fuel prices going forward’. The airline stated it’s fuel-hedging strategy has ‘always been to hedge fuel requirements whenever an attractively priced structure is available’, going on to say that ‘fuel hedging is an important component of our strategy as it provides us with clarity over our cost structure; this will allow us to manage our seat inventory better and aids route development. We are averse to risks and therefore believe in mitigating those risks by removing variability and uncertainties from our business whenever suitable opportunities arise. 13

Prior to a trade being executed, one would have assessed the current operating and market conditions before choosing the appropriate hedge. Therefore, the decision to hedge begins with a view.’ At the time that the airline undertook its hedge in Jul-07, the airline had a view that oil prices of above USD90/barrel will be a result of ‘excessive speculative market action in that commodity’. Fuel price volatility intensified in the later part of the 2007-2008 due to higher fuel consumption projections, supply disruptions, geopolitical risk concerns, and the weakening of the US Dollar. Due to the high volatility in oil prices, the airline is of the view that adopting a static hedged approach (through fixed/plain vanilla swaps) at current price levels would involve taking excessive risks. If one were to opt for a fixed swap now and should fuel prices retrace subsequently, AIRAsia would be left with effectively an obligation to purchase expensive fuel with no room to manoeuvre out of the position. Therefore, the airline opted for a dynamic approach and layered fuel hedge structures. AIRAsia are confident that this is the most suitable approach to manage the high volatile fuel prices and will continue to apply this strategy in the future. AirAsia continued on to sat that it approaches the fuel hedging subject “carefully” and that it has ‘maintained a conservative stance which has resulted in positive contributions from our past fuel hedges. This has ultimately benefited the Company in reducing the total fuel bill and hence enhance our ability to offer low fares to our guests’. Over the past two months, foreign funds have been reducing their exposure in airline stocks. In fact, the majority of prominent LCCs around the world have experienced heavy sell downs. Based on this, AirAsia stated it would be ‘inappropriate to lay the blame on our fuel hedges as the reason for the decline in the Company’s share price’. With this fuel hedge in place, and assuming that the strong demand and pick-up rate that we are seeing is sustainable, the Company is in a sound position to deliver strong profit growth for the financial year barring any unforeseen events and circumstances.” AirAsia has been profitable for all but the second half of 2008, when Mr Fernandes decided to unwind fuel hedges before most other airlines took the plunge. After taking an initial hit, AirAsia is now getting the full benefit of oil at $40 a barrel while some rivals are still paying $100. That decision is typical of Mr Fernandes’s willingness to break ranks. When other airlines slashed advertising during the SARS scare in 2003, AirAsia tripled its spending. 14

“Expanding where demand is falling is a major concern because there is a risk of its ticket sales not matching its capacity growth. Fact is, share prices move according to market expectations, and the current market expectation is rather negative,” says an analyst. However, some analysts do acknowledge that AirAsia’s strategy has well positioned the group to emerge as one the strongest aviation players once the market condition improves. “We defy logic. Our view is that people still want to travel in a down market, and they are most likely going to trade down in order to save more money,” Fernandes says. “Even if our regular customers may cut down on their travel with us, we will gain some new customers who previously use premium flights,” he adds. The migration of passengers who are price-sensitive has enabled AirAsia group to gain new ground. While the group’s focus has always been on the non-business, leisure sector, it has, of late, seen the increase of business travellers on its flights. Azran opines that the current environment may hurt airlines in high-cost positions, but AirAsia group is set to benefit from the slowing economy because of its ability to offer comparatively lower fares. AirAsia believes that most passengers do not have loyalty to any particular brand because their choices depend on ticket prices. “Therefore, we believe demand for budget travel is here to stay,” Azran says, adding that AirAsia X is currently operating on a positive cash flow because it has already sold tickets for travelling period of up to the middle of next year. Survival of the fittest The first half of this year, during which crude oil prices were rising to record levels, was a turbulent period for the aviation industry as a whole. Several low-cost carriers (LCCs) have since ceased operations because of their inability to cope with the high fuel prices. This list includes Hong Kong’s Oasis, Indonesia’s Adam Air and Thailand’s One-Two-Go. 15

The closure of these airlines is boost to AirAsia’s market share and enhances its position as the ultimate leader in the region’s low-cost sector, says a local analyst. Bahrain-based Perigon Advisory, which manages the Manara Infrastructure Fund, is confident that AirAsia group has the marketing know-how and X-factor to capitalise on such opportunities that arise from its competitors falling out of the game. “The group has been able to take its business to successful level because it has a deep understanding and discipline in following its low-cost model,” says Perigon Advisory partner Michael Rodriguez. AirAsia has managed to ride through the stormy period, with a net profit of RM9.42mil for the second-quarter (2Q) ended June 30, 2008. The figure represents a 95% year-on-year (y-o-y) decline, mainly due to its high translation loss of RM77mil resulting from the weakened ringgit. The 65% y-o-y increase in its unit fuel costs from US$86.20 per barrel to US$142.5 per barrel during the period had also eaten into AirAsia’s profit. On a positive note, AirAsia actually recorded a rise in its passenger numbers by 20% y-o-y from 2.3 million to 2.8 million for 2Q08, despite its average fares rising 16% y-o-y from RM170 to RM198. Its revenue for the period under review rose an impressive 41% y-o-y from RM432mil to RM608mil. These are factors that have provided AirAsia group the edge over its major rivals, some of which are still using inefficient planes that are as old as 10 to 15 years and operate on a complicated system that requires high maintenance. In addition, the sharing of resources, such as the online booking platform and cabin crew, between AirAsia and AirAsia X has enabled the group to operate on high economies of scale. This is more to the benefit of AirAsia X, which according to Azran, is on track to achieve profitability by next year.Azran also reveals that the group has hedged 100% of its fuel at US$115 per barrel for up to the end of the year. Despite having its flight destinations and frequencies severely limited by the Malaysian government under a protectionism policy for MAS in the early days of its operations, AirAsia has over the years built an amazingly strong brand presence in many international markets. Many observers have attributed AirAsia’s success to the leadership of Fernandes. A great strategy will not be effective if there is no team work, says H. Dale Ichida, the managing director for aviation and alternative investments for ORIX Corp. “AirAsia has the right 16

corporate culture to grow. There is no bureaucracy and Fernandes is easily accessible to his staff members, hence enabling important discussions to take place on the spot. In a competitive environment, corporate bureaucracy can impede growth,” Ichida says. Virgin group’s Baxby and Perigon Advisory’s Rodriguez also believe that the management philosophy practised by AirAsia group is the key element to its success. “Fernandes has used his entrepreneurial skills, something which is intangible, to steer the company out of difficult times before, and we believe his management philosophy will continue to promote the growth of the group,” Rodriguez shares.

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VII.

SWOT ANALYSIS of AIRASIA

>> 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 lowcost carriers for a given stage length (route distance in miles). AirAsia has the following sources of cost savings in comparison with the full service airlines : Lean Product - AirAsia’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, AirAsia has added seats. AirAsia 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. Quicker turnaround times - While most full-service airlines like Jet take at least an hour to leave an airport after landing there, AirAsiadoes it in 15-20 minutes for ATRs (and about 30 minutes for its new A320 service.) So, if AirAsia 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 18

carrier is able to keep its planes airborne for 11 hours a day. This allows AirAsia 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 - AirAsia 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 - AirAsia 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. AirAsia 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 : AirAsia has the advantage of being the first low cost airline in Asia. 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 AirAsia 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. Brand Equity : AirAsia will most certainly have a sustained mind share in the Asia Region consumer’s psyche. They will always be remembered as the airline that took the initiative (and the risk) to reshape an industry inside out. AirAsia’s CEO, Tony Fernandes will most certainly go down in the annals of history as the man who changed the civil aviation dynamics in Asia forever. AirAsia was the first airline that made air travel affordable to all Asians. This brand equity is a major strength that AirAsia must successfully capitalize.

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>> 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. Questionable on-time performance – Limited aircraft also means unavailability of standby planes in the event of operational problems. At present, AirAsia is not known for maintaining a good on-time performance. This will over time, erode brand equity and alienate the timeconscious business traveler. Shaping up on-time performance records by eliminating sources of teething troubles is critical. >> OPPORTUNITIES Un-serviced Hinterland - 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. There are large areas of trade and commerce in the rural hinterland that are pockets of prosperity which are yet unserviced. 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. 20

Huge Market Potential - In a country of a billion people, the Indonesian aviation industry is puny. Indonesia 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 Indonesia. 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 AirAsia 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 Indonesia has grown during the last there of 2005-08 as compared to the same period last year, as per estimates of Amadeus Worldwide. Product differentiation – At present, AirAsia 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. >> THREATS Killer competition – The Asia Region skies are witnessing a bloody battle for market shares. A much anticipated fare war has broken out across Asia Region skies. AirAsia is still a gowing airline company, but a medium-big player in the Asia Region skies. They are vulnerable to price cuts by large-existing players with deep pockets. Aviation experts are betting could start a debilitating price war to push the fledgling no frills airlines off the tarmac - permanently. 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 AirAsia, 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. 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. 21

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 Asia Region 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. Open skies policy – The opening up Asia Region skies to foreign carriers is being debated at great length by the Regional Government. Should this happen, there will be an influx of global players in the Regional market. Their long years of experience in markets abroad and financial strength will be a threat to AirAsia. Poor Airport Infrastructure – Airlines like AirAsia 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 AirAsia or its followers for some time to come. Abroad, low cost airlines avoid flying into mainland airports and, therefore, don't incur high parking and landing fees.

VIII. DISTINCT CUSTOMER SEGMENTATION

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New Markets will be created through distinct customer segmentation. This echoes the vision of AirAsia’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. –

The entrance of low-cost airlines will push customer segmentation

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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 priceconscious customers (low cost airlines) and for quality-conscious customers (full service airlines)

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There will be stiffer competition for non-business passengers and price-conscious business passengers on short routes

IX.

AN ANALYSIS OF POSSIBLE COMPETITIVE SCENARIOS 23

The following are the possible future competitive scenarios that AirAsia may be faced with1. Competition within current business design : AirAsia 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 AirAsia, 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 AirAsia’s ticket prices. Another competitive tool is to enhance frequencies on the sectors and step up customer loyalty campaigns. 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 AirAsia, with even last minute deals that are as attractive as or even better than AirAsia. 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 shortterm 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 24

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. 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 offshoots 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 25

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. 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 Asia Region skies, following the success of AirAsia. 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. AirAsia 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

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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.

REFERENCES www.AeroMorning.com Alexander, Keith L. (2004). The Economics of Low Cost Carriers - All the Numbers Add Down for the Nation's Low-Cost Carriers. Washington Post, Feb 29, 2004. Economist, The (2004). Low Cost Airlines – Turbulent Skies. Economist Print Edition – July 89, 2004.http://www.economist.com/business/displaystory.cfm?story_id=2897525

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www.Financialwire.net. COMTEX Hecker, JayEtta Z. (2004, June 3). COMMERCIAL AVIATION - Despite Industry Turmoil, Low-Cost Airlines Are Growing and Profitable. United States General Accounting Office - Testimony Before the Subcommittee on Aviation, Committee on Transportation and Infrastructure, House of Representatives. Kong, Ying & Le Dressay, Andre (2003). Spinning off low cost carriers – When does it make sense? Journal of the Academy of Business & Economics, April 2003. Schneiderbauer, Dieter & Fainsilber, Olivier (2002). Impact of Low Cost Airlines – Summaryt of Mercer Study. Mercer Management Consulting. Subramaniam, Ganapathy G. (2004). Cheap, cheerful & chock full. Times News Network, Aug 27, 2004.

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