Monday, February 27, 2006

Start-ups: Upcoming Short Series

We’ll be putting together a short series on just a couple of the start-ups in the market for capital. This post is a brief primer on the start-up environment in early 2006.

It is apparent to just about everyone by now that starting new airlines is a favorite pastime of the wealthy, the not-so-wealthy, and everyone in between. There is a tried and true collection of jokes about start-ups. You know…they usually start with something like, “Do you know how to get a million dollars quickly?” …We’ll spare you from reading the punch-line.

Well, the start-up business plans keep coming. What is interesting is that some of these start-ups are capturing the attention of the most reputable segments of the industry. Why? For starters Virgin America captured the attention of Airbus, Boeing, GECAS and others very early on in their financing process because the team had the Virgin name on the cover page of its pitch book and because they had a rich billionaire behind them. Some of the other start-ups out there have done it the hard way. Yes, solid business plans have been built up slowly over many years, data has driven strategic planning (not the distant location of a relative of the CEO), and solid management teams have been recruited. Important is the fact that the giants of the industry such as the major lessors and banks recognize that there is a big opportunity right now for new entrants in the US. What opportunity? Doesn’t the market have too much capacity, not too little?

Let’s just skim the surface here instead of giving the long answer:
Ryanair cost per passenger: $46
easyJet cost per passenger: $76
Southwest cost per passenger: $94

So do Ryanair and easyJet have incredibly low costs or does Southwest have high costs?

Short answer: Southwest has high costs.

Slightly longer answer: Ryanair, easyJet, Gol, and Air Asia all learned from Southwest and each other and have perfected the point to point low cost model. Put simply, the highlights of the successful point to point model include flying lower stage lengths (maximizing departures per day per aircraft), high seat density, and scaleable networks that drive productivity. Wage rates are important too, but their importance tends to be greatly overstated by American legacy carrier CEOs who have no choice but to go after the low hanging fruit that pay rates are.

Luckily for Southwest, just about every other carrier in the US has higher costs than it does, thus its strong market position. Incredible as it may seem, the true low cost model described above is not practiced by any other US airline…beside Southwest. Unfortunately for Southwest, its desire to grow roughly 10% per year has driven the carrier further and further away from the network structure that drove its low costs over the past few decades. It is true; after all, that Southwest’s cost advantage today has as much to do with fuel hedging as any other factor. It’s equally true, however, to say that the only way its balance sheet was strong enough to hedge when they did and to the level they did was because of the adherence to the pure point to point low cost model that it practiced through the 90’s (this subject is worthy of a separate post …it’s amazing how many slides of other airline’s that I had to sit through at the JP Morgan conference last week whining about Southwest and its hedges).

Although Southwest’s employees are still very productive, they are becoming less so because the pursuit of the growth opportunities that the airline needs to impact its earnings do not fit the point to point low cost model that got it where it is today. And, after 30 years, a legacy structure will develop along with higher wage rates. That will catch up with just about any carrier of that age. Southwest is no exception. It has the highest wage rates in the industry in many of its labor groups.

So there is no reason why much lower costs than Southwest (let alone the majors) can’t be achieved in the US market by a new entrant. That is why there is an interest in start-ups. The American airline’s cost structures are unnaturally high and that presents opportunity in the largest air service market in the world. The story on the cost side is set.

Now the problems begin. Where do you find the revenue? And, if you find it, do the opportunities properly fit the point to point low cost model described above? Just about every revenue opportunity in the States is being hoarded by the existing carriers, and those carriers won’t give up most of their sources of revenue without a fight. In these cases of aggressive revenue protection, the low cost provider is usually not the survivor. Why? Could those economics books we all took in the first year of undergrad actually be wrong? Well, this isn’t a game of economics. It’s a game of politics. United lost untold millions by competing head to head with Independence at Dulles…during their bankruptcy. Even in bankruptcy, the existing carriers have enough power with frightened creditors and politicians to afford to try to kill new entrants that attempt to poach long-held revenue streams. These new entrants need to spend more time in refining their revenue strategy than in any other area. If the revenue strategy is developed properly through credible political partnerships, competitive diversification and/or insulation, then the next crop of start-ups just might have a chance to thrive. We’ll get into the individual revenue strategies of the start-ups we profile as this series unfolds.


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