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Low Cost Vs Full Service Airlines

March 17, 2010

This aviation cycle commences with 5 meaningful players (vs. 3 in previous cycle). FSCs [full Service Carriers] have long argued that LCC [Low Cost Carriers] cost structures are very similar to FSCs, except that the former enjoy unit costs that are 15-20% lower, given greater seat density on fleet. We believe that capital costs, a reflection of balance sheet health, will be key differentiators in this cycle given that pricing will be far more important in the current cycle.

After a sharp (MoM) decline in Feb, LCC fares (average on routes we survey) have risen c10% over Jan, implying that service charges and fuel costs have been passed through. FSC fares are up ~6.5% over the same period.

The managements of full service carriers (FSCs) have argued – somewhat unsuccessfully – over the past 5 years that given the relative parity in costs for FSCs and LCCs, the latter’s unit costs are not structurally different, especially when adjusted for the difference in seat density. LCCs typically have around 180-200 seats/plane (vs. FSC at ~140-150) hence, given that costs are
defrayed over a larger base, they are ~20% lower (per seat). Without this differentiation, there is little in terms of cost structure to meaningfully differentiate.

In FY10 (9 month data annualized) we note that capital costs for Jet as % of revenues are almost 10ppt higher – a structural overhang. LCCs will thus be better positioned to pursue growth and profit objectives, as they can utilize this 10ppt cushion to either price tickets lower – and attract more passengers – or raise fares and profitability, and still effectively compete with the FSCs.

Fares Analysis – LCC and FSC Fares Narrow this Month

LCCs continue to price far more aggressively than FSCs, though the differential between FSCs and LCCs has decreased dramatically MoM and is now in line with trends exhibited over the past few months.

There has been a recent sharp increase in LCC fares, while FSC fares have held firm thus far. Both FSC and LCC fares have risen MoM to pass on fuel cost increases and also service tax imposition.

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