Overcoming the threat of low cost carriers: The effects of partnerships and imitation Iberia airline business case Anuroopa Kataria (6126391) Universiteit van Amsterdam MSc Business Studies - Strategy track Supervisor: Drs. J.G. de Wit 11 July 2014 Abstract As a response to the increasing threat of low cost rivals on short haul markets that jeopardize the hub & spoke system, full service airlines attempted to capture this threat by forming partnerships with these competitors or imitating them. The implemented strategies are aimed at lowering the high cost structure of full service airlines for short haul operations, to similar cost structures of the low cost rivals. Simultaneously, full service airlines are required to maintain the connectivity of their hub & spoke system as part of their competitive position. The aim of this study is therefore to examine the actual effectiveness of strategies of partnership and imitation regarding cost reduction and connectivity by analysing Iberia airline that implemented the dual strategic action of imitation and acquisition. The airline formed a partnership by acquiring low cost airline Vueling and applied the strategy of imitation by developing low cost subsidiary Iberia Express. The analysis is based on Iberia’s annual reports, OAG data of Iberia’s route schedule and reports of CAPA. The results indicate that subsidiary Iberia Express indeed contributes to a lower cost structure on the short haul operations of Iberia as well as improved connectivity for Iberia’s network system. Vueling on the other hand, expands Iberia’s network with an intra-European network on hub Barcelona. The operations do not interfere with the hub & spoke system of Iberia in Madrid, so Vueling does not affect the connectivity of Iberia’s hub & spoke system. In this way, Iberia controls the low cost competition both in Madrid and Barcelona and therefore accomplishes a successful implementation of both the acquisition strategy and imitation strategy. 2 TABLE OF CONTENTS I. Introduction 4 II. Changing business models 6 III. Dynamic capability view 9 IV. Partnerships & Imitation 12 4.1 Non-equity based partnership: alliances 12 4.2 Equity-based partnership: acquisitions 15 4.3 Imitation: airline within an airline 17 V. Iberia airline business case 19 VI. Summary & research question 22 VII. Research methodology 24 7.1 Research design: case study 24 7.2 Research instruments and procedures 24 VIII. Results 26 8.1 Costs 26 8.1.1 Operating performance & CASK 26 8.1.2 Passenger number & share 30 8.1.3 Labour costs 32 8.2. Connectivity 37 8.2.1 Total number of flights 37 8.2.2 Types of flights 38 8.2.3 Top ten routes 39 8.2.4 Substitution and expansion of Iberia’s route network 40 8.2.5 Hub & spoke system of Madrid 42 8.2.6 Hub & spoke system of Barcelona 47 IX. Discussion 50 9.1 Imitation: Iberia Express 50 9.2 Partnership: Vueling 53 9.3 Limitation and future research 54 X. Conclusion 55 XI. References 57 XII. Appendix 1: list of figures and tables 64 XIII. Appendix 2: airport codes 65 3 I. Introduction A threatening announcement in the Financial Times at the end of last year reads: ‘Europe’s airline distinction blurs as strategies merge‘ (Barber, 2013). What has happened since the 1980’s, when liberalization emerged in the European airline industry? In short, it led to changing business models (Vlaar et al., 2005). Before this period, only two types of players operated in the industry: legacy and charter airlines. Nowadays there are charter carriers, leisure carriers, hybrid carriers, low cost carriers and full service carriers (Klophaus et al., 2012; Wensveen and Leick, 2009; Doganis, 2001; Alderighi et al., 2005). Obviously, competition increased massively, especially for full service airlines. On one hand, their long- haul routes suffered from competition due to the increasing numbers of airlines with a hub- and-spoke system and because of the rise of Gulf carriers (Graham, 2009; O’Connel, 2011; De Wit, 2013). On the other hand, short-haul routes of full service airlines suffered from the growth of low cost carriers; over the years, these airlines have gained market share of 47% (Doganis 2001; Alderighi et al., 2005; CAPA, 2013). As a result, the hub & spoke system with connections between short-haul and long haul routes came into jeopardy. Full service airlines experienced difficulties managing the competition of the low cost players because their cost structure goes far beyond the cost structure of low cost airlines (Dennis, 2007). Consequently, full service airlines were forced to lower their cost structure for short haul operations in order to improve their competitive position and trying to obstruct the jeopardy of their network system. As a first attempt, full service airlines developed low cost subsidiaries, also known as airline within an airline concept (Morrell, 2005). KLM for example, tried to survive in the market with low cost airline Buzz while British Airways developed the airlines GO. Both of them were unable to make the strategy successful. They had difficulties managing a completely different business model, opposite of their own core ideology, whilst being bound to long-term contracts with suppliers and other external parties. 4 Later on, additional forms of cooperation such as acquiring existing low cost carriers were implemented (Lenartowisz et al., 2013). In 2009 Lufthansa, for example, acquired the low cost market leader in Germany; Germanwings (CAPA, 2013). Recently, full service airlines are considering the possibility of forming alliances with low cost carriers. Airline alliances ‘SkyTeam’ and ‘Star Alliance’ want to offer a partnership platform for low cost carriers (CAPA, 2013). In this way, full service airlines can cooperate with low cost airlines through code sharing and other non-equity forms of cooperation (Oum and Zhang, 1996; Das and Teng, 2000). Whereas previous literature focuses on the threat phenomenon that full service airlines experienced after the liberalization and imply diverse strategies of cooperation and imitation, little evidence exists regarding the actual effects of these strategies with regards to cost reduction and connectivity in the hub-and-spoke system. Therefore, the aim of this research is to analyse effects of partnerships and imitation on the possibility of cost reduction and improvements of connectivity of the hub-and-spoke system. The study contributes to the existing literature with an analysis of effective responses of full service airlines to the threats of low cost carriers as well as giving new insights to airline managers for future strategic actions they should take in order to transform the competitive threat of low cost carriers into a permanent opportunity. The structure of the paper is as follows: first an overview of the existing literature on the changes in business models is outlined, after which the theoretical framework and research design of the business case will be examined. Next, the results of the analysis will be presented and discussed and finally, the conclusion will be provided, including the limitations and implications for future research. 5 II. Changing business models This section goes in-depth in the developments after the liberalization that has led to the successful low cost carriers on one hand and the threatened full service carriers on the other.The deregulation in 1983 caused new opportunities for European carriers to compete on international markets and other markets that were closed before (Oum et al., 1995; Doganis, 2001). For flag carriers as well as charter airlines, reacting to this situation meant reconsidering and innovating their business models (Chesbrough & Rosenbloom, 2002). Chesbrough & Rosenbloom (2002) characterize a business model as being comparable to a marketing strategy; it is a ‘plan of action’ how to sell and target a product, eventually to make money. It comprises of a framework representing airlines’ corporate core competences, value chain activities, assets and capabilities (Daft & Albers, 2011). The flag carriers started to offer high frequency flights on routes that generated huge amount of traffic, while minimizing frequency on routes with a small amount of traffic (Oum et al., 1995). Destinations with minimized route frequencies became attainable with indirect flights via the high frequency routes; connecting on specific primary, base airports of the airlines (hubs). In this way, the hub and spoke system emerged. The target customers are widespread: from quality conscious passengers to price conscious passengers and from business passengers to leisure passengers. Therefore, the value propositions for passengers are also prevalent with different travel services based on different seat classes and booking classes. Free food and beverages; the offer of frequent flyer programs with access to business lounges and privileged sky-priority handling are examples of such value propositions. The assets that are required to carry out the value propositions include multiple aircraft types (with relative low utilization rates), complex fare system with different booking codes through yield management and most importantly large number of personnel (Wensveen and Leick, 2009; Vlaar et al., 2005). So, the high costs of managing this system are derived from transfers and connections of different planes. In the 6 same way, delivering high service raises the costs of maintenance and overhaul; passenger services expenses, flight operation costs and mostly personnel costs, both ground staff as flying staff (Doganis, 2006). Full service airlines also face the responsibilities of long-term contracts with a network of stakeholders, including various suppliers, which have to be carefully managed, because these airlines are serving several markets (Pels, 2008). Overall, the competitive strategy is centred on differentiation by offering high service and transfers through connecting flights. Former charter airlines took another approach in changing their business models as a response to the opportunities that occurred after liberalization. Part of charter airlines developed in leisure airlines with seasonal and occasional low-priced flights.