Flight Plan
The local airline industry undergoes a makeover
By Noel G. Reyes
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| “Our corporate mission is to make flying more affordable, ” says Cebu Air CEO Lance Gokongwei, who is steering Cebu Pacific’s transformation into an LCC |
The global airline industry has run into heavy headwinds the past few years, greatly hindering airline companies’ recovery and financial progress. It has been crisis following on the heels of another crisis as far as the industry is concerned—the September 2001 terrorist attack, the Iraq war, SARS, among others.
Local airlines are likewise flying through the thick of these winds of change currently buffeting the global industry. Just like the rest of the world, they have flown right smack into a crude oil price crisis.
PAL’s Response
“The initial response of the company in view of fuel price surges in the world market was to collect fuel surcharges from passengers,” explains Jaime Bautista, president and chief executive officer of Philippine Airlines, the country’s industry leader. “However, since this was not enough to fully mitigate the effects of increasing fuel prices and there is also a limit to the amount of costs that can be transferred to the passenger, the company implemented fuel hedging programs. With the assistance of IATA (International Air Transport Association), we also conducted an audit focusing on fuel conservation programs.”
The fuel surcharges appended to airfares cover only 60% to 70% of the rise in fuel prices, Bautista points out, leaving the balance to be offset by savings elsewhere. For instance, among the IATA recommendations is the installation of a computer system that helps the pilot time the plane’s take-off and landing in a fuel-efficient manner. PAL’s fuel hedging program, meanwhile, already covers 60% of the airline’s fuel requirements and is a source of competitive advantage over its competitors. Hedging functions, which also include managing foreign exchange risks, form part of its treasury operations’ risk management section. Foreign currencies account for over 70% of PAL’s revenues, of which 60% come in U.S. dollars. This allows the company to use the dollar as its functional currency in financial statements, as per the new international accounting system.
In addition, PAL reduced each plane’s load to conserve fuel by “reducing carriage of nice-to-have” things, such as newspapers. It also de-rated some plane’s engines to less-powerful engines while maintaining safety standards.
“Going forward, the company will acquire fuel-efficient aircraft to replace gas-guzzling ageing aircraft,” relates Bautista, adding that PAL’s fuel expenses have so far climbed to 30% of total expenses in 2006 from 25% in 2005. Even so, this proportion is still lower than the rest of the industry’s, clearly as a direct consequence of the company’s hedging operations.
For PAL, refleeting not only forms a proper foil for soaring aviation fuel prices but also serves a dual purpose: as a strategic response to the sudden challenge of a fledgling airline modeled on the success of low-cost carriers (LCCs) now flying across the U.S., Europe, Asia, and even Africa.
Cebu Pacific’s Transformation
Cebu Air, led by its young chief executive, Lance Gokongwei, has embarked on transforming itself into an LCC upon completion of its own refleeting program and realignment of the company’s corporate ethos and processes. Gokongwei also recently took on the position of president and chief operating officer of JG Summit Holdings, a diversified conglomerate started by his father, John Gokongwei Jr., with interests in banking, food manufacture, hotels, real estate and property development, retail, petrochemicals, power generation, publishing, telecommunications, and textiles. The younger Gokongwei has been at the helm of Cebu Air, which operates the Cebu Pacific airline, for 10 years now and thus readily admits to considering the company as his “baby.” Adding to his parental pride in the company, Lance was awarded last March as the country’s Entrepreneur of the Year by the U.S.-based professional services firm Ernst & Young in recognition of his leadership of Cebu Air.
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| This scene at the Manila Domestic Airport is indicative of the growth of the local airline industry, which saw a sharp 35% growth in July |
Late last year, Cebu Pacific fired the opening salvo by launching its “Go fares,” which the company describes as “permanent—not promotional—low fares available year round.” Go fares are limited to a small number of seats per flight and are offered as early as three months ahead of the time of actual flight. As per LCC practice, Cebu Pacific unbundled the airfare, quoting this exclusive of taxes, insurance, and fuel surcharge.
Early in 2006, Cebu Pacific went even further, marking its 10th year of service by offering a promotional one-way airfare of P10 to any domestic destination for travel from June to October. It allocated more than 100,000 seats but sold more than 150,000 seats during the promo period that ran from 3 to 8 March. Those who thought that was the end of it had to do a double take when, three weeks later, the company came up with an even lower discounted airfare. From 29 March to 2 April, Cebu Pacific offered more than 50,000 airfare tickets for P1 to any of its domestic destinations also for travel from June to October. The company lay claim to the title of “low-fare leader” with a vengeance.
Follow the Leader
Where Cebu Pacific led, the rest of the industry had to follow willy-nilly lest they should face a mass exodus of passengers to the audacious challenger. The Gokongwei airline’s fare structure started with the heavily discounted fare that had to be booked well in advance, steadily rising to the highest-fare bucket price for late-booking passengers. Its shift to price competition has had a profound effect on the local airline industry, much like the effect of the entry of any discount-fare airline in other countries. The rest of the local airlines had to follow its lead in discounting fares and thinning down their operating margins, wiping them out in some cases.
But following Cebu Pacific’s lead does not necessarily mean catching on to what it aims to accomplish. One airline executive even went so far as to say that Cebu Pacific’s actions could destroy the industry, leaving no victors. “They’re doing that [heavily discounting fares] to gain market share and [thereby] justify their huge investment in a new fleet of aircraft,” said the airline executive.
PAL’s Bautista appears to share the same sentiment. “They’re trying to buy the market” with cheap fares, he said, adding that Cebu Pacific is not really gaining market share but succeeding in attracting the “boat market,” or those who customarily travel by boat among the country’s islands. In truth, passenger-ship operators have been forced to likewise benchmark their rates against Cebu Pacific’s discounted airfares.
Growing the Market
“Our corporate mission is to make flying more affordable” by democratizing airfares, emphasizes Gokongwei, as he debunks the sentiments of his industry peers. “We shall accomplish that mission by being approachable, inexpensive, convenient, and fun.” He adds, “We are growing the market, not taking market share from PAL or Air Philippines.” The latter is the third-largest airline in the country-and has the same majority owners as PAL.
“We are stimulating the market by making it more affordable,” explains Gokongwei. What this strategy has accomplished so far is already remarkable: 80% of Cebu Pacific’s clientele consist of “people who did not fly before, or did not fly frequently.” The local airline industry, which had been growing at a sedate pace of 3% to 4% each year, saw a sharp 35% growth spurt in July this year. For July, Cebu Pacific achieved a market share of 43%, not that far from PAL’s 47%, discloses Lance.
A clear vision of what is happening in the global airline industry and where the local industry is headed—these keep Lance Gokongwei awake at night, pushing him to transform his company into a low-cost airline. “It’s just good business practice, if you see the trend abroad. LCCs are here to stay. These will be the preferred mode [among airline passengers] for short hauls,” explains Lance. Foreign LCCs operating in secondary airports such as Subic have already gained a foothold. What’s to prevent them from entering the main market, he points out.
On the other hand, the local airline market can be stimulated with lower airfares to levels of passenger volume similar to Indonesia, Gokongwei predicts. Indonesia currently flies 28 to 29 million passengers each year, compared to the Philippines’ 7 to 8 million passengers. Given the same per capita consumption of air travel, stimulated by a more democratic airfare structure, the Philippines should rightly see 10 to 11 million airline passengers per annum. Seeing the current trend continue, Gokongwei anticipates 15 to 16 million airline passengers annually for the country three to four years from now, more than double the 2005 level.
Competitive Environment
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| For PAL president and CEO Jaime Bautista, “Competition is always welcome—it makes us more efficient and we can’t afford to be complacent” |
Which is not to say that the competitive environment is benign. Quite the contrary, Gokongwei describes the competition as “intense.” “PAL is not sitting still,” he says. “Both of us are transforming ourselves. There’s still room for two or more players in the industry.” For his part, Bautista asserts, “PAL has a very positive view on competition. The company believes that competition develops a new riding public, introducing them to the convenience of air travel vis-à-vis other modes of transportation. Competition has benefited the traveling public by giving them more choices and better products at lower costs. Competition is always welcome—it makes us more efficient and we can’t afford to be complacent.”
The competition is not merely on airfare. More fundamentally, the clash is between two business models. On the one hand is the long-established hub-and-spoke or network airline mode favored by the large airlines versus the LCC or point-to-point system favored by the nimbler and smaller airlines. “There can be only one PAL,” acknowledges Gokongwei, referring to the fact that there is room for only one successful hub-and-spoke operator in the country.
But the contrast between the two business models can blur in some areas. Cost-cutting measures available to LCCs are also being adopted by network airlines. The key to an LCC’s success is, at the outset, to build up a cost gap with competitors, which would then allow it to pass on the savings to its customers while building up traffic volume and maintaining a healthy margin.
Cost Efficiency
Cebu Pacific’s business model, Gokongwei explains, is to fly point-to-point instead of operating on a hub-and-spoke, have a mono-class service (no business class), maintain just one type of aircraft (Airbus 320 fleet), and limit the range of flights to less than four hours one way.
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| Cebu Pacific’s US$670-million refleeting program will bring the number of its
new Airbus 320 units to 14 by February 2007, giving it the distinction of having the
youngest fleet in Asia |
The company’s new Airbuses, which will rise to 14 after it acquires 4 more planes by February 2007, will translate to lower maintenance costs and lower fuel expense per passenger seat. Fuel expense accounts for over 40% of operating expenses, up from about 20% only five years ago. Each airplane costs US$60 million, entailing a US$670 million refleeting program that will result in the company’s having the youngest fleet in Asia. With the new aircraft, airplane reliability is placed at 12 to 13 hours each day versus the 6 to 9 hours that the old fleet of DC-9s gave the company. Short hauls and short ground turnaround of 30 minutes, meanwhile, mean high aircraft utilization. The end result: low cash cost per available passenger seat.
Also part of Cebu Pacific’s business model is to outsource maintenance to SIA Engineering, a unit of Singapore Airlines, thereby allowing it to “focus on flying, marketing, and distribution.” Online distribution of tickets through e-ticketing is another main component of the model. In addition, “we took out the newspapers, took away the frequent flyer program, took out the lounge, and just deliver the services that passengers are willing to pay for,” Gokongwei explains. Cebu Pacific stops short of a purely LCC model and had to compromise, he adds, given the Filipino culture and the company’s heritage. Thus, although the airline no longer serves in-flight food, it still serves beverages and provides parlor games as part of its corporate heritage.
Differentiating Services
PAL has likewise adopted a number of LCC initiatives but prefers to differentiate its services rather than compete on airfare. For one thing, points out Bautista, most of PAL’s domestic flights are point-to-point. It offers promo fares but doesn’t advertise these. The company has likewise embarked on a refleeting program, opting for nine narrow-body Airbus 320s with 156 seats (144 allocated for economy and the rest for business class), to be flown on domestic and regional routes. The list price for this refleeting program comes up to US$840 million, with the new planes replacing an ageing fleet as well as taking the place of planes whose leases had run out.
PAL’s strategic response to the challenges posed by the LCC model is to fall back on its market leadership, brand loyalty, and the continued comfort of flying. “We are the preferred carrier—experience of 65 years, service is different, pride in a good safety record and the goodwill this entails, aircraft maintenance by Lufthansa, and we have the PAL learning center.”
Bautista further explains: “PAL understands that the transition of the new market environment will not be immediate nor be automatically more cost-effective. This, however, drives the need for better market penetration, competitive fare structures, and a realignment of the company’s cost base with such competitive fare structures. PAL also offers a value-for-money product that includes, among other things, a frequent-flyer program, better terminals, better schedules, network connectivity, and onboard amenities at no additional cost, for example, meals, in-flight entertainment, newspapers, overnight kits, and increased seat pitch.”
PAL’s main market remains the loyal Filipino travelers who look for that distinctive Filipino service that makes them feel like they’re already home upon boarding the airplane.
Towards a Win-Win Situation
Global developments and intense local competition are changing the face of the Philippines’ airline industry. Certainly, one sector already benefiting from these changes are the travelers who are enjoying the airlines’ cheaper airfares and wider range of services. The local airlines are banking on their respective business models and strategic decision making to make this a win-win situation all around.
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