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Surveying The Landscape

Canadian airline growth has been higher than in the United States, where major carriers have adjusted to shrinking capacity and shedding unprofitable routes that fail to meet ROIC (return on investment capital) targets. Air Canada’s Rouge and WestJet’s Encore, meanwhile, have been growing at an impressive clip.

“WestJet has a green field opportunity,” says Robert Kokanis, president of Air Trav, a Toronto-based consultancy. “They are going to many markets where Air Canada Express has enjoyed a monopoly or dominant position. That will continue as Encore rolls out across the country.” And while the addition seats put pressure on existing capacity, both airlines appear to be increasing the pie by stimulating traffic with lower air fares. “It is not a situation where we see a problem,” says David Tyerman, a transport analyst with Canaccord Genuity. “Many of the [new services] are on low competition routes with high
prices. They seem to be able to fill the airplanes and do it profitably at a reasonable return. If you look at the earnings and invested capital of Air Canada and WestJet, they have been improving.”

Volatile fuel prices and investor pressure – especially from American investors – for Canadian operators to match the higher returns of many U.S. airlines may slow the rate of growth. But there will not be a large-scale shakeup in Canadian air transport over the next five years even with the anticipated arrival of at least one Ultra Low Cost Carrier (ULCC), which given past performance may be a shakeup unto itself.

Expect instead, tinkering along the margins. Indeed some of the actions
taken by Canadian carriers in 2014, such as WestJet’s launch of its first trans-Atlantic flights to Ireland from Newfoundland, Rouge’s plan to break into the Asian market and leisure carrier Sunwing’s strategy to capture a sliver of the Canadian market travelling to U.S. airports to avoid taxes and fees could hold clues to what the landscape may look like in 2020. With all of these elements at play, Wings tries to make predictions on some of the issues that may help to shape the future of Canadian aviation.

Gorilla Warfare: the gorillas in the room
It has been almost 10 years since discount airline Jetsgo departed the scene. Canada remains one of the only developed economies not to be served by an ultra low cost carrier (ULCC) such as Southwest and Allegiant in the United States, or Ryanair in Europe. It is inevitable that a ULCC would snatch market share from established players, but they also stimulate growth with lower fares based on a no frills business model that packs customers into the airplane and offsets the lower yields through ancillary revenue. Last year, Ryanair took in US$1.6 billion (24.8 per cent of revenue) in ancillary sales, according to IdeaWorksCompany, a U.S.-based consultancy specializing in airline revenue.

While Canada lacks the population density of the U.S. and Europe, many industry watchers believe there is room for a ULCC to fly below Air Canada and WestJet’s fares on Canada’s 20 busiest city pairs, and in many secondary markets. At least two western-based groups think they can break the decade-long duopoly: Canada Jetlines in Vancouver and Jet Naked in Calgary. Nobody expects the duopoly to roll over.

“Air Canada and WestJet have not been sitting still when it comes to lower cost offerings,” Air Trav’s Robert Kokonis says. “Rouge could be deployed on domestic routes and Encore is flying at a lower cost per seat mile than WestJet’s mainline carrier. All it will take is for Air Canada and WestJet to open up the spigot on the lowest pricing bucket of economy class seats and these airlines are going to have a problem.”

Air Canada chief executive, Calin Rovinescu confirmed he would consider putting Rouge up against a ULCC entrant. “There’s nothing preventing us from using Rouge in the domestic market, and we will look at it on a market-by-market basis,” he recently told analysts.  

Both Canada Jetlines and Jet Naked are planning to launch next spring with Airbus A319 and Boeing 737 services to secondary western destinations respectively. Of the two, Jet Naked appears to have the inside track. Tim Morgan, the company’s executive chair is a co-founder of WestJet and chief executive of Enerjet, a charter operator with a fleet of three 737-700s. The company has also been stocking the executive suite with talent from Spirit Airlines, a Florida-based ULCC. Over 38 per cent of Spirit revenue came from the sale of ancillary services, including the sale of Free Spirit mileage points to loyalty program partners.

“There is the potential for Jet Naked to do better,” says David Tyerman, an analyst with Canaccord Genuity. “The ULCC model is reasonably well known, but if you have never done it directly, I wonder if you will have the experience to pull it off.”

Rick Erickson, head of R.P. Erickson and Associates based in Calgary, is cautious about any ULCC thinking they can dust off the original WestJet business model and apply it to today’s marketplace. “Starting with three aircraft, slotting yourself around the majors in western Canada and putting jets into secondary markets is no longer going to work,” he suggests. “Where you could see success with a ULCC is if you ‘big bang it’ – come in with 15 airplanes and start up so quickly and fast that the majors cannot match you on fare for every single flight.”

That may be too big to ask for potential investors who are already spooked by the likely response of Air Canada to WestJet to a ULCC threat. “Obviously the financing side of this is a challenge,” Tyerman notes. “They have been looking for money for a while now and I am not seeing any signs that they are about to launch.”

Easing the 25 per cent limitation on foreign ownership of a Canadian carrier may spur an outside operator with deeper pockets to support a ULCC. Ottawa has been promising to raise the limit to 49 per cent for years, but nobody is predicting that anytime soon. (For more of ULCC’s in the Canadian market see, “Can a low-cost option survive?” pg. 14)

Prediction: At least one Canadian ULCC is going to challenge the marketplace, although spring 2015 is perhaps a bit optimistic. Whether an upstart will have the staying power to 2020 will depend on the appetite of investors to endure a full court press by the reigning duopoly. A consumer-friendly Ottawa could level the playing field, but actions to open up the mobile phone sector offer little encouragement.

Stemming the bleeding: cross border shopping
Taxes and fees continue to chip away at the number of Canadians flying out of home airports. In 2012, the Canadian Airport Council (CAC) estimated that the “cross border shopping” of air travel resulted in 4.8 million Canadians using border airports to take advantage of cheaper tickets.

Air Canada has big plans for the 787, as it is already financially committed to this aircraft and the 737-MAX. PHOTO: Air Canada

Air Trav’s Robert Kokonis says the number has likely swollen to 5.5 million, and is set to go higher as a result of Ontario’s decision to phase in a tripling of its aviation fuel tax to 6.7 cents per litre, and the potential for runway expansion at New York’s Ogdensburg Airport, a one hour drive from Ottawa. U.S. ultra low cost carrier Allegiant is adding Ogdensburg to its route network, bringing an onslaught of cheap seats for bargain hunters in the Ottawa area.

The drain to the U.S. is primarily driven by the leisure sector. Whatever the final number, it is not telling the complete story, says Daniel-Robert Gooch, president of the CAC. “The bleed to the United States is really a symptom of a much bigger problem,” he said. “What we can’t see so easily as those [leisure] travellers who go to the U.S. are those who don’t fly, including business travellers. It also doesn’t show people who are now taking less efficient modes of transportation, such as loading up the car and driving across highways when it makes more sense to fly.”

All of this is having a “knock on” effect on other businesses such as hotels, restaurants and airport concessions. Dr. Fred Lazar of the Schulich School of Business at Toronto’s York University estimates that increases in the Ontario fuel tax could result in a $97-million hit to the province’s GDP and a loss of more than 2,000 jobs. “It’s no longer about stopping the bleeding,” Kokonis says. “It’s about how to stop increasing the bleed.”

One Canadian airline has decided to place the bucket on the other side. Toronto-based leisure carrier Sunwing is using the fine print (see, On the Fly, pg. 8) in the Canada/U.S. open skies agreement to operate two weekly services to Cancun, Mexico and Punta Cana in the Dominican Republic. “Sunwing is simply acknowledging we are losing all these folks south of the border,” Kokonis points out. “They are just satisfying demand in the market.”

Is this the start of a trend? Canaccord Genuity’s David Tyerman doesn’t see it. “A scheduled carrier like Air Canada and WestJet can’t do it, because we don’t have cabotage in Canada. Canadian airlines are going to have to keep going to the government to get relief on the costs they face in Canada that American carriers don’t face. In the absence of relief, they are going to keep competing as best they can. But they are probably going to keep losing the very price conscious part of the market to border airports.”

Still, the Sunwing decision has drawn fresh attention to the issue. The problem is the number of hands in the cookie jar, which has enabled the collectors of various fees and taxes to minimize the impact of their own charges by casting blame elsewhere. A spokesperson for the Ontario government, for example, noted that Sunwing was planning flights out of Buffalo before the increase in fuel taxes was added to the 2014 Budget. “Each individual charge doesn’t add up to much,” says Gooch. “But the entirety of the fees and taxes on a ticket adds up to something that is very real. It is death by a
thousand cuts.”

Gooch says that the industry and government must work collectively to lower the overall cost burden. Kokonis agrees. “Individually, none of these extra taxes and fees are enough to make or break a family of four getting in a car and driving across the border. We have to address the cumulative effect that is making the decision for a family to go south.”

At the same time that higher costs are causing Canadians to either abandon air traveller plans or seek price relief in the U.S., they also appear to be a barrier to entry for some airlines, which clears a path to higher fares. “We are seeing airlines that are hesitating to come to Canada,” Gooch points out. “Lower charges and new carriers coming in and providing greater competition in the marketplace would actually do something real on the cost of air travel in Canada.”

In April 2013, the Senate Transport Committee urged the federal government to stop charging rent to local airport authorities. Transport Canada is once again looking at the issue of costs. Does this spell relief finally on the horizon? Tyerman is not optimistic. “The industry is a major generator of jobs and is at a competitive disadvantage. The government is well aware of this but has still concluded that these fees make sense and are needed for whatever is important to them.”

Prediction: There are signs that Transport Canada is concerned over the cost competitiveness of air transport in Canada, but must also butt heads with Treasury, which will be reluctant to give up the $250 million a year in revenue that flows into its coffers from airport rent. Expect some lowering of taxes and fees over the next five years, although for the most part these cuts will be a symbolic nod to public pressure and are not likely to stop the flow of bargain seekers driving to U.S. border airports, or stimulate the market. Over the next five years, the value of the Canadian dollar and gasoline prices may have a greater influence on where Canadians chose to fly from.

Re-fleeting: will the CSeries find a home in Canada?
Canada’s two mainline carriers will take delivery of more than 120 airplanes over the next five years as they seek to expand globally and support their domestic turf. The shopping list includes 14 Boeing 787s for Air Canada, which will accelerate the shift of older Boeing 767-300ERs to its low cost Rouge operation, and 62 Boeing 737s (including 39 of the 737-MAX) for WestJet and 13 Bombardier Q400s, which the carrier will use on its Encore regional brand.

WestJet, which had placed a firm order for 20 Q400s, recently exercised options for an additional five aircraft. Encore is ramping up to expand into eastern-Canada and the transborder sector, which means that an order for additional Q400s is inevitable.

Air Canada will begin taking deliveries on the first of 61 737-MAX aircraft as part of its North American fleet renewal. WestJet will break into the wide-body segment in late 2015, when it acquires four pre-owned 767s from Boeing, although it is not clear whether these airplanes were purchased or leased.

In 2013, Air Transat announced a fleet restructuring plan that included adding permanent and seasonal 737-700s and reducing the size of the Airbus 310 and A330 fleet by 2015. In July, the airline renewed six of its A330 eases at terms that outweighed the advantages of seasonal subcontracting as originally envisioned.

Air Transat will operate 21 wide-bodied aircraft during the 2015 summer season. Despite the higher cost structure of flying a fleet of ageing A330s, analysts do not expect the airline to move away from the type in the foreseeable future. “Some players may have to rethink fleeting,” said David Tyerman of Canaccord Genuity, “but you have to the equation of [lower] capital costs against [higher] operating costs. In a varying fuel price environment, you can come up with different answers as to what the optimal aircraft is.”

Aviation consultant Erickson points out that this is the “genius” behind Air Canada’s Rouge product. “Rouge airplanes have got very high airframe cycles on them. If you have got a brand new 787 you have to fly the wings of those airplanes or you run into grief on the capital amortization of the aircraft. Rouge 767s are already written down. You can fly them seven or eight hours a day and still make money.”

Erickson believes the same thinking helped to guide WestJet’s decision to first enter the wide-body sector with older 767s, but expects to see the launch eventually followed with an order for 787s. “WestJet wouldn’t have any trouble getting 787s and would probably get delivery positions advanced a bit by Boeing because they are such a good customer. They chose an aircraft that doesn’t have a high capital costs. But long thin routes are where WestJet will be able to make money in the international area. The 787 is the airplane of choice for that.”

This could ultimately put the Airbus A350 in play for an operator such as Air Transat.  “Over the long term, all airlines move toward more efficient airplanes,” Tyerman notes.

Meanwhile, eyes are on Bombardier and whether the CSeries jetliner will fly commercially under a Canadian registration. In September, Bombardier received a firm order for 40 of the larger CS300s by Macquire AirFinance, a Dublin-based aircraft leasing company. This came on the heels of a relatively successful Farnborough Air Show, where the customer list grew by four to 20. “They had a good Farnborough,” Tyerman observes. “Most of the orders were LOI’s (letters of intent), but Bombardier has a good track record of converting CSeries LOI’s into firm orders.”

More difficult to land has been a firm order in the airframer’s backyard. Air Canada’s decision last spring to not replace up to 25 Embraer 190s was a blow to Bombardier, which was considered a “shoo-in” for the order. An order by Porter Airlines for 12 CS100 aircraft is conditional on Toronto City Council, lifting a jet ban and approving an extension of the main runway. Last spring, council voted for to send the proposal for further study, effectively kicking the can to May 2015.

“Air Canada is already financially committed to the 787 and 737-MAX. From a financial standpoint they can look at the CSeries right now. WestJet has already moved as far from its roots as a single type carrier as they are willing to go. It comes down to whether Porter gets the go ahead to the CSeries from Toronto’s island airport. That might ratchet up the pressure at Air Canada, but given the financial pressures, that might be five years from now.”

Prediction: The bulk of orders for new airplanes between now and 2020 have already been made. WestJet will place additional orders to bolster its Encore Q400 fleet. Expect Air Canada partners such as Chorus Aviation to continue to modernize its fleet to reduce costs and compete against Encore. It is interesting to note that Bombardier recently delivered its first 86-seat, extra capacity Q400 to Nok Air, a Thailand-based, domestic low cost operator. Depending on the success of its international expansion, WestJet will also place an order for newer wide-body aircraft, likely the 787, although an increase in the 767 fleet as an interim measure cannot be ruled out. Air Canada may still be interested in the CSeries, but for now the odds of that airplane operating domestically appear to rest on Porter Airlines and Toronto City Council. A majority of Torontonians support the city centre airport, although the city is split on expansion. The newly elected Mayor supports jets. The outcome may rely on his powers of persuasion.