BCG Market Study 2011

The European Short and Medium Haul Airline Market
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This market study is based on information available as of October 24, 2011
Disclaimer
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Contents
1 Executive Summary ........................................................................................................................ 7 2 Context and Focus of the Study .................................................................................................. 10 3 Market Development in 2010 and 2011 ...................................................................................... 11 3.1 Demand ...................................................................................................................................... 11 3.1.1 Overview of the Main Demand Drivers ............................................................................. 12 3.1.2 Recent Demand Development ........................................................................................... 12 3.1.3 CIS Market Demand ......................................................................................................... 13 3.1.4 Future Demand Development ............................................................................................ 13 3.1.5 Demand Correction Factors ............................................................................................... 14 3.2 Supply ........................................................................................................................................ 14 3.2.1 Overview of the Main Supply Drivers ............................................................................... 15 3.2.2 Overall Supply Development ............................................................................................ 15 3.2.3 Supply Development in the Full Service Segment ............................................................. 17 3.2.4 Development in the Low Cost segment ............................................................................. 20 3.2.5 CIS market Supply ............................................................................................................ 22 3.2.6 Future Supply Development .............................................................................................. 23 3.3 External Factors .......................................................................................................................... 23 3.3.1 Fuel Costs ......................................................................................................................... 23 3.3.2 Airport and Navigation Costs ............................................................................................ 24 3.4 Yields ......................................................................................................................................... 24 4 Development Scenarios for 2012-2015 ....................................................................................... 25 4.1 Scenario 1: Growth ..................................................................................................................... 26 4.2 The Growth Scenario Impact ....................................................................................................... 27 4.3 Scenario 2: Low Growth ............................................................................................................. 30 4.4 The Low Growth Scenario Impact ............................................................................................... 31 5 Appendix 1: Scenario Reasoning ................................................................................................ 34 5.1 Macroeconomic Factors .............................................................................................................. 35 5.2 LCC Progression......................................................................................................................... 36 5.3 Demand ...................................................................................................................................... 36 5.4 Supply ........................................................................................................................................ 38 5.5 Airline Costs ............................................................................................................................... 40 5.6 Yields ......................................................................................................................................... 41
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Figures Index
Figure 1 Intra-Europe airline traffic trends ............................................................................................ 13 Figure 2 Capacity trends in intra-European air travel ............................................................................ 16 Figure 3 Short-haul ASK year-on-year growth comparison of LCCs and FSCs ..................................... 17 Figure 4 Cost variances between FSCs and LCCs ................................................................................. 21 Figure 5 Sources of LCC advantage ...................................................................................................... 21 Figure 6 Short haul vs. long haul yield and ASK ................................................................................... 24 Figure 7 Approach used for definition of the scenarios.......................................................................... 25 Figure 8 Growth Scenario: Demand, supply and yield development ...................................................... 29 Figure 9 Growth Scenario: Unit costs and revenues .............................................................................. 29 Figure 10 Low Growth Scenario: Demand, supply and yield development ............................................ 33 Figure 11 Low Growth Scenario: Unit costs and revenues .................................................................... 33 Figure 12 Main parameters and assumption about their development .................................................... 34 Figure 13 Relationship between business confidence and air travel demand in Europe .......................... 37 Figure 14 Narrow body fleet growth to be driven by LCCs current status (ACAS database) ............... 39 Figure 15 Estimated oil price development (Brent, USD/bbl) ................................................................ 40 Figure 16 CASK and average stage length of European carriers ............................................................ 41 Figure 17 LCC penetration putting pressure on FSC yields ................................................................... 42 Figure 18 Effect of changing PAX mix ................................................................................................. 43
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Tables Index
Table 1 Overview of main scenario parameters ....................................................................................... 9 Table 2 Parameters of The Growth scenario ...................................................................................... 27 Table 3 Parameters of the The Low growth scenario.......................................................................... 30 Table 4 Real European GDP growth estimations ................................................................................... 35 Table 5 Estimations of inflation and exchange rates development ......................................................... 35 Table 6 Estimations of LCC market share on European SH market ....................................................... 36 Table 7 Expected demand evolution ..................................................................................................... 37 Table 8 Expected supply development .................................................................................................. 39 Table 9 Expected real SH yield development ........................................................................................ 41 Table 10 Gap between supply and demand ........................................................................................... 43
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Glossary of Terms
ACAS AEA ASK Aircraft database; database providing data about aircraft in use (age, delivery schedules, owners etc.) The Association of European Airlines; association representing 35 main European airlines Available seat kilometers; measure of airline production showing total number of seats available on scheduled flights multiplied by the number of kilometers these seats were flown Compound Annual Growth Rate; year-on-year growth rate over a specified time Cost per ASK; average operating unit cost per seat kilometer flown CASK excluding the costs of fuel Central and Eastern Europe Commonwealth of Independent States, formed by Russia and several former Soviet republics Emissions Trading Scheme; European scheme of carbon emissions reduction Full Service Carrier (e.g. Lufthansa, Air France) International Air Transport Association; represents, leads and serves the airline industry, comprised of 230 member airlines International Monetary Fund; intergovernmental organization promoting economic cooperation among countries Low Cost Carrier (e.g. Ryanair, easyJet) Load Factor; RPK divided by ASK, measure of capacity utilization expressed in the percentage of available seat, weight or freight capacity Passenger Revenue per ASK; unit revenue of an airline Revenue per tone-kilometer; unit of cargo airline productivity calculated as a number of tones of cargo, multiplied by kilometers this cargo has been carried Revenue passenger kilometers, the number of paying passengers carried on scheduled flights multiplied by the number of kilometers these passengers were flown Passenger Revenue per RPK, measure of average fare paid per kilometer per passenger by dividing passenger revenue by RPK
CAGR CASK CASK ex-fuel CEE CIS ETS FSC IATA IMF LCC LF PAX RASK RTK RPK Yield
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1 Executive Summary
In 2010 and first half of 2011 the European airline market was characterized by demand growth acceleration and yield improvement In 2010 and the first half of 2011, the European airline market had returned to growth with average y-o-y RPK increases of 5%, driven by both long haul (LH) and short haul (SH) Demand growth outpaced supply in 2010 and especially early 2011, stimulating plans of carriers to add capacity The emerging gap between demand and supply caused improvement in load factor by ~2 p.p. and real yields by 2% year-on-year in 2010 The CIS region saw an impressive RPK increase of ~26% in 2010 while it is expected to conclude 2011 with a 10% growth There is a considerable uncertainty at the end of Q3/2011 regarding development beyond this year. It concerns macroeconomic stability and growth, resulting air traffic demand and the ability of airlines to adequately react to demand fluctuations Continued deleveraging across Europe and a slump in private consumption has put pressure on GDP growth forecasts Leading indicators such as business growth confidence, air freight volumes and forward bookings clearly point to a slowdown in air traffic demand towards the end of 2011 Since supply reacts to demand with a lag, questions arise regarding supply adaptation to the potential recession scenario by the end of 2011 Two scenarios, The Growth and The Low Growth Scenario, were designed in this study to draw boundaries of market developments beyond the end of 2011 (for detail see Table 1) European SH markets are in the midst of a structural change characterized by air travel commoditization brought by LCCs; the scenarios model the effects of economic fluctuations on the structural change and its overall impact The scenarios primarily differ in the GDP outlook for 2012-2015, as GDP is the principal driver of air traffic demand Airline supply then follows demand in both scenarios, albeit with limited ability to respond to larger and abrupt changes LCC progression is generally accelerated by weak economic conditions The supplydemand gap together with LCC market share are the primary determinants of yield development In the Growth Scenario, moderate growth of air traffic demand fuelled by a relatively stabilized economic environment results in a slower real yield decline and helps FSCs to reduce the loss of SH market share to LCCs This scenario assumes the real GDP growth rate between 1.5% and 2.5% p.a. (slow-down in 2012, accelerating in 2013-2015), with the corresponding air traffic demand growth of 2-4.5% p.a. Induced changes in air traffic demand will be limited in rate and magnitude, allowing carriers to minimize excess supply
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The relatively stable economic outlook will slow down the progression of LCCs and also partially limit its impact on SH yield
The yield decline is assumed to be slower in the Growth Scenario enabling FSCs to gradually optimize their networks and focus on growth within their most profitable SH routes FSC SH are expected to see difficult 2012 followed by a slow recovery in 2013-2015 Profitability of SH routes will decrease but remain sufficient for FSCs to keep most of the routes in operation despite some not being LH feeders Big FSCs with LH routes (Air France, IAG, Lufthansa) will continue to cross-subsidize their SH feeders and gradually restructure their networks and cost base Smaller CEE airlines (e.g. CSA, LOT or Malev) will complete their respective restructuring processes and look for strategic partnerships LCCs will expand steadily with RPK and ASK growing by 6% p.a. Despite the overall decrease in PAX traffic profitability, the LCC segment will remain profitable in 2012-2015 In the Low Growth Scenario, the assumed economic downturn in 2012 would slow down air traffic demand and cause real yield decline faster than historical average; weaker economy will favor LCC progression causing further pressure on yield The Low Growth scenario assumes a GDP decline of -1% in 2012 followed by a 1% growth in 2013, 1.5% in 2014 and 2% in 2015 The corresponding air traffic demand growth will range between 1% and 3.6% p.a. within this period Carriers will not be able to match capacity with the demand development and resulting excess capacity will further reinforce downward pressure on RASK Weaker economic conditions will accelerate the transition of travelers to LCCs, thereby contributing to further downward pressure on yields Overall, the Low Growth Scenario thus results in faster SH yield decline forcing FSCs towards substantial restructuring and withdrawal from weaker SH routes The decline in demand in 2012 and 2013 causes a real SH yield drop by -4% p.a. necessitating CASK improvements Profitability of FSC SH routes continues to suffer unless FSCs apply deep structural changes. Big FSCs with LH routes (Air France, IAG, Lufthansa) continue cross-subsidizing their most profitable SH routes and retreat from the weakest SH routes; strong focus will be put on cost optimization Smaller CEE airlines (e.g. CSA, LOT or Malev) will be even more pressed to succeed in their respective restructuring endeavors and concluding strategic partnerships LCCs will benefit from increased point-to-point traffic and the FSC retreat from SH, and gradually overtake attractive SH routes feeding main hubs The LCC segment remains profitable in 2012-2015 despite lower PAX traffic profitability. The two scenarios do not assume any potential structural discontinuity in the market, which contributes to the conservative nature of the presented outcomes Major shift in large FSC cross-subsidization of SH from profitable LH business is not anticipated Market withdrawal of any major airline is not assumed
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Translation of fuel price increases onto customers via increased yield is not assumed (i.e. higher fuel prices will result in lower profits of airlines) No fundamental change in European airline regulatory environment is expected to take place in 2012-2015 (e.g. full market liberalization towards non-EU carriers or new taxes) The CIS region is assumed to remain regulated and governed by bilateral agreements, which together with weaker infrastructure and informal barriers to competition results in continued resistance to LCC growth Table 1 Overview of main scenario parameters
Parameter Inflation Exchange rates Jet fuel cost1 Real GDP growth
Description Europe EUR/USD Price in USD/t Europe
Scenario All All All Growth Low Growth Growth Low Growth Growth Low Growth Growth Low Growth Growth Low Growth
2011P 2.7% 1.39 876 2.4% 2.4% 4.0% 4.0% 38% 38% 6.5% 6.5% -5.0% -5.0%
2012F 1.9% 1.27 988 1.5% -1.0% 2.0% 1.0% 39% 41% 3.0% 2.5% -3.7% -5.0%
2013F 1.9% 1.29 1 042 2.3% 1.0% 3.5% 1.5% 40% 43% 3.5% 3.0% -2.5% -4.6%
2014F 1.9% 1.32 1 042 2.3% 1.5% 4.0% 2.6% 41% 45% 3.5% 3.0% -2.8% -2.6%
2015F 2.0% 1.34 1 042 2.5% 2.0% 4.5% 3.6% 42% 46% 4.0% 3.5% -3.0% -2.1%
Demand
PAX volumes intra-Europe Intra-European PAX market share Short haul ASK growth
LCC progression
Supply
Real Yield
Short haul real yields
Due to high level of uncertainty regarding fuel price development, identical values are assumed for both scenarios. These values are based on consensus forecast by 15 investment banks as of October 24, 2011.
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2 Context and Focus of the Study
The purpose of this study is to review recent developments on the European airline market and provide an outlook for the 2012-2015 period. The study focuses on continental Europe along with the Nordics, Balkan and Turkey. The view is completed with a recount of Russia and the other CIS countries. The study looks at short haul (SH) and medium haul (MH) passenger traffic (both business and leisure in their intra-regional transfer and regional forms) but at the same time, an influence of long haul (LH) traffic is taken into account as well. The business models covered in this study include full service carriers and low cost carriers in their pure as well as hybrid forms. To provide a comprehensive picture, networks based on both hub and city-pairs are considered. This study utilizes two distinct scenarios to set the boundaries of future development. For the purposes of scenario definition, the overall market focus is divided into Europe and CIS as these two markets are likely to develop differently. While the European market is relatively saturated, stable and deregulated, and has already seen a fast growth of LCCs, the CIS is strongly affected by valid bilateral agreements and mostly served by local FSC carriers. The study seeks to answer questions regarding future development on the focus markets and their possible impact on FSC carriers operating on short- and medium-haul routes within Europe and between Europe and the CIS.
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3 Market Development in 2010 and 2011
In this chapter we provide an overview of the development of the European airline market in 2010-2011 as well as the basic trends for beginning of 2012. We briefly describe the situation of the air traffic demand in the regions of Western Europe, CEE and CIS and then follow with summarizing the airline supply on the respective markets. Looking at the supply in detail, we briefly examine situation of three distinct clusters of market players: major airlines (Lufthansa, Air France - KLM and IAG), group of CEE airlines (CSA, LOT and Malev) and the LCCs. Finally, we conclude the chapter by describing the main external factors affecting the European airline business (prices of fuel and airline airport and navigation costs) and by touching on the latest development of European airline yields. The turbulent developments of European airline market in the past two years culminated by the dichotomous market dynamic of 2011. While the nominal effects of the new financial crisis are already visible, the magnitude of their real impact is not clear yet. The 2008/2009 crisis had a strong negative effect on European airlines, but recovery started as early as 2010. Both demand and revenue growth picked up in 2010 and reached upper single figures at the beginning of 2011. We can say that the period of 2010/2011 consisted of three distinct phases: the post-crisis recovery in 2010, the growth in the first half of 2011 and yet another slow-down that is anticipated in its second half. In the first half of 2011, the demand advancement outpaced the capacity, which led to increases in load factors and therefore increase of yields (supported also by growth of business travel). However, in the second half of 2011, the EU countries started once again to anticipate real effects of the sovereign debt crisis, virtually wiping out further business growth expectations for Q4/2011 and 2012. Despite that, new capacities were still being added in that period resulting in pressure on yields and load factors and the corrections of the capacity growths are announced to come in effect as late as winter 2011. These corrections do not include only the most FCS but some low cost airlines2 as well. Prospectively, we expect that a lower real GDP growth and worsening customer confidence will likely affect both leisure and business travel on the intra-European routes, particularly in the short term. However, there still is a large degree of uncertainty as to the extent of the impact. For this reason, we developed two scenarios for the next five years (see Chapter 4) that differ in the anticipated impact of the sovereign debt crisis on European economy in the near future and in the pace of recovery in the following years until 2015. 3.1 Demand
We start this section with description of the main drivers for air travel demand. Then we briefly summarize the latest development in 2010/2011 and the basic trends we expect for early 2012 in the regions of Western Europe, CEE and CIS. Finally, we provide an overview of the main demand correction factors we used in our market models. In 2010 and the first half of 2011, the European airline market had seen signs of return to the regular growth with average year-on-year RPK increases of around 5%, driven by both long and short haul traffic. Unfortunately, subsequent signs of subsiding demand, indicated by decline of forward bookings and airfreight volumes, accompanied by weakening business confidence started to lurk after the first quarter of
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Source: IATA Industry Outlook, September 2011 (http://www.iata.org/whatwedo/Documents/economics/IndustryOutlook-September2011.pdf)
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2011. Despite that, the growth of demand for long haul travel is estimated to amount to 8% in 2011, and on the short haul (intra Europe) it should reach 5%. This improvement of intra-European traffic in 2011 should be driven mainly by LCCs as it translates to 3.1% for FSCs and 8% for LCCs. The CIS region saw an impressive RPK increase of ~26% in 2010 and is expected to conclude 2011 with a demand growth around 10%. Generally, the region shows strong air traffic potential and in the long run a steady 4.2% RPK CAGR is expected for the region in the coming 20 years. 3.1.1 Overview of the Main Demand Drivers
The principal driver of air transport demand is the economic growth. Within Europe over the past 10 years, the economy expanded on average at around 2.5% p.a.3, while the call for air travel, expressed in RPK, grew on average by 6% annually4. Segment-wise, this demand growth was driven mainly by LCC, regionwise it was skewed towards CEE countries. The demand is on the other hand constrained by factors which include airport capacity limits, competition of high-speed trains or air travel taxes. Last subsection is devoted to the external factors affecting air travel that we consider in our market models. The passenger air traffic demand can be decomposed into two basic components: leisure and business travel. The leisure demand is more dependent on GDP-driven disposable income and strongly affected by prices of travel alternatives. The travel for business, on the other hand, is less price sensitive as it is closely correlated with the growth of international trade and business confidence in the manufacturing sector. 3.1.2 Recent Demand Development
In 2010, the airline market had seen first signs of a return to growth with a 5% year-on-year RPK increase. Long haul traffic (entirely constituted by FSC carriers) grew by 2%, while the more agile short haul grew at 7%. In the short haul segment, LCCs continued to gain market share: while FSC short haul RPK increased only by 3%, LCCs growth has accelerated to reach 14% year-on-year. FSCs and LCCs concluded 2010 with 62% and 38% market shares respectively. 2011 is the year of growth in both long haul and short haul segments, especially in view of Q1 results. In 2010 IATA forecasted a 5.3% growth for 2011 (4.5% short haul, 5.9% long haul) and Jan-August 2011, figures that would point to a far better result. However, by Q2 it became clear that the rate of progress would not last (see e.g. Figure 1). The third quarter started to show strong signs of weakening demand indicated by continuous devolution of forward bookings and airfreight volumes5. Additionally, business confidence levels have been steadily declining since their peak in Q1 to the point where business growth is currently expected to stop6. Following, low growth expectations and low confidence will have a real impact within a short time. European carriers would then face a decrease in demand by the end of 2011 and in early 2012. This leads us to an adjusted growth estimate for 2011 with 6.1% overall growth. In this setup, the long haul segment would turn up at 8 %, leaving 5% for short haul. The 5% overall short haul growth then translates to 3.1% for FSCs and 8% for LCCs.
3 4 5
Source: Eurostat (http://epp.eurostat.ec.europa.eu/portal/page/portal/hicp/data/database; October 2011) Source: AEA Monthly Traffic Update, November 8; LCCs annual reports (available up to 2010) Source: AEA - AEA News, Issue no.3, October/December 2011; IATA - Airline Business Confidence Index, July 2011 Survey; Airlines reports (September and October 2011) Source: European Commission - Business And Consumer Survey Results from September 2011
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Intra-European airline traffic trends, August 2011

PAX (ths.)
9 000 8 000 7 000 6 000 easyJet 5 000 Air France/KLM 4 000 3 000 2 000 1 000 0 -8 -6 -4 -2 0 2 4 6 SAS Cimber Sterling IAG Aer Lingus Finnair 8 10 Blue1 12 14 16 18 20 22 Vueling Norwegian Air Berlin Lufthansa Group Ryanair
Aug-2011 PAX growth (%)
Source: CAPA Centre for Aviation and company reports
Figure 1 Intra-Europe airline traffic trends
3.1.3
CIS Market Demand
Russian and CIS economy moderately grew in 2010, at real GDP growth of 4.3%. Russia accounts for the majority of the region's GDP (70% in 2010) and consequently also most of the air traffic. The region's GDP is expected to grow at 3.4% p.a. over the next 20 years7. Regarding air travel demand, the region saw an impressive RPK growth of ~26% in 20108 (~60% constituted by domestic travel) and we expect it to conclude 2011 with a 10% boost. In the long run, a steady 4.2% RPK CAGR is expected in the coming 20 years. This growth is further supported by government investments in airport infrastructure. For example, the runway at Moscow's Domodedovo airport is planned to be replaced in 2015, thus helping the airport to become the major hub by getting to a capacity of 50 million passengers per year9. Yet this is still conditioned by agreement between the government and the current airport owners. 3.1.4 Future Demand Development
Looking at the immediate future, the end of 2011 and early 2012 are seen to be problematic as the slowdown of winter cycle may coincide with full effects of the new financial crisis.
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Source: Boeing Current Market Outlook 2011-2030, 2011 Boeing Based on CAPA Centre for Aviation, see e.g. http://www.centreforaviation.com/analysis/russia-can-lay-claims-tobeing-one-of-the-worlds-most-dynamic-air-transport-markets-57461; http://www.centreforaviation.com/news/russian-traffic-up-123-in-jan-aug-2011-122198 Source: Airport webpages, May 25, 2011, http://www.domodedovo.ru/en/main/news/press_rel/?ID=3093
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Winter months will mitigate most leisure travel that kept summer growth numbers high, especially for the LCCs. Also the continued drop in business confidence, that was observed from the second quarter and which reached zero growth expectations by August and September, will start to severely impact premium travel. Subsequently, by the end of 2011, the 3-6 month lag usually observed between drop in business confidence and the effect on travel for business intensity will have elapsed. Additionally, leading indicators such as airfreight volumes confirm this hypothesis. To draw the picture, airfreight variations tend to precede passenger travel by ~6 months and a strong cutback is already to be seen in the period between May to September 2011. The freight RTK of AEA carriers dropped within this timeframe by ~10% 10. All these facts lead us to the conclusion, that a large degree of uncertainty exists beyond H1 2012, which is therefore covered by the developed scenarios. 3.1.5 Demand Correction Factors
This study considers several external factors affecting air travel, which include airport capacity limits, competition of high-speed trains, the European Emission Trading Scheme and further taxes. Compared to earlier forecasts, lower expected traffic levels diminish the impact of airport constraints and cut the number of IFR departures back by 100,000 in 2017 (0.8% of total impact growth over 7 years)11. Continuing improvements in the high-speed train network is another factor that is concentrated mainly in Spain, Turkey and France. The current view is that it shall reduce the number of flights by about 47,000 (0.4%) over the next 7 years. Again, this is less than last years forecast12. Concerning the regulatory environment, the effects of aviation joining the European Emission Trading Scheme (ETS) in 2012 are expected to cause further reduction of demand by 0.3%12. Furthermore, additional pass-through taxes may be levied on passengers in some European countries. Aving the latest evidence in Germany, it is clear that this can further reduce demand as well, affecting the LCCs more than FSCs due to their lower price base. 3.2 Supply12
In the following sub-sections we provide a brief overview of the main supply drivers and the latest development trends of supply in the intra-European air transport. Thereafter, we describe the most recent activities of key players active in the regions of Western Europe, CEE and CIS both in the FSC and LCC segments. Two FSC groups are described below in accordance with the scope of the study the three main European players (Lufthansa, IAG and Air France-KLM), and the group of the main CEE airlines (e.g. LOT, CSA, Malev). In the LCC segment we evaluate the main LCC competitors that are active in both Western Europe and CEE regions. Following the crisis year of 2009, the European airlines overall increased ASK by 2% in 2010, driven by a 15% expansion of LCCs on short haul. FSCs remained flat both on their short and long haul routes. Opposed to 2010, the year 2011 is to conclude with FSC expansion. Overall, European ASKs are expected to go up by 9%, with a 12% growth in long haul (FSC only) and 6.5% in short haul. It is worth to mention
10 11 12
Source: AEA News, Issue No. 3, October-December 2011 Source: Eurocontrol, Medium-Term Forecast, February 2011 Unless stated otherwise, the data presented are entirely derived from three sources: CAPA Centre for Aviation (see e.g. http://www.centreforaviation.com/analysis/), AEA and individual airline reports available in October 2011.
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that majority of the short haul expansion is driven by LCCs with 9%, while FSCs are expected to add 5% to their ASK. Looking at the matters in detail, this study briefly examines activity of three distinct clusters of market players: Major airlines (Lufthansa, Air France - KLM and IAG ), the group of CEE airlines (CSA, LOT and Malev) and the LCCs. In the first group, we see each of the three large airlines taking a different approach to the continuing negative SH development. Lufthansa is currently focused on restructuring its group to achieve higher efficiency and assessing sale of some of its companies. The freshly created IAG is focused on search for synergies resulting from the merger of BA and Iberia meanwhile also trying to reverse Iberia SH traffic decline by establishing new LCC in Spain. Air France is currently preparing to implement a large operational efficiency program. In the second group, we see most of the CEE airlines in a state of restructuring and downsizing their networks. As they operate mainly on the SH routes between Eastern and Western Europe, they share common aims to escape from the losses they suffered in 2009/2010 and to attract potential strategic partners either from one of the big three airlines or even one of Asian carriers. To conclude, LCCs finished 2010 with strong 38% intra-European passenger market share and still grew strongly in 2011 especially in the summer months, riding on the wave of leisure travel. Their growth is expected to continue, despite currently observed fluctuations: The large Ryanair and EasyJet are cutting capacity, while Wizz Air and Norwegian are still growing. Air Berlin is undergoing a restructuring. In the CIS region we expect that the international air travel market remains regulated and governed by bilateral agreements. Combined with weaker infrastructure, this results in continued resistance to LCC expansion and the increasing air traffic demand will therefore be captured by large domestic FSCs led by Aeroflot and other main players (e.g. Transaero, S7)13. 3.2.1 Overview of the Main Supply Drivers
The key drivers of air traffic supply include resource costs, competitive environment, government regulations, airport and airspace capacity and demand. Of all the supply drivers, in the short and medium term, air traffic supply is most strongly correlated with demand projections. Yet, the carriers have to strongly rely on their market analyses and forecasts as the airline ability to change its capacity in short term is strongly limited. A lag is however observed between demand trends and airline reactions. This lag is caused by supply rigidity caused by aircraft delivery times and the fixed summer/winter flight schedule cycle that offers only limited windows for adjustments. The extent of airline reaction also differs between FSCs and LCCs. While FSCs will react to demand drop by a slower combination of capacity and fare decrease, LCCs leverage the competitive cost structure, using price as the fast key balancing mechanism to keep constant high seat load factors. 3.2.2 Overall Supply Development
As far as European ASK supply is concerned, 2010 saw an overall increase by 2%. While long haul remained flat, short haul routes ascended by 5% year-on-year. This short haul advance has in its entirety been driven by LCCs growing at a fast paced 15%, while FSCs remained flat - European FSCs have not
13
See e.g. CAPA Centre for Aviation, http://www.centreforaviation.com/analysis/russia-can-lay-claims-to-being-oneof-the-worlds-most-dynamic-air-transport-markets-57461 from 19th August, 2011
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expanded in any segment in 201014. For an overview of intra-European short haul capacity development see Figure 2 below. As opposed to 2010, 2011 is looking at some FSC expansion. Overall, the European ASKs are expected to grow by 9%, with a 12% growth in long haul (FSC only) and 6.5% in short haul. It is worth noting that majority of the short haul expansion is driven by LCCs (See Figure 3 below) with 9% growth, while FSCs are expected to add 5% to their ASK.
Year-on-year capacity increases 2009-2011 in all months except ash-stricken April 2010
Departing seats (million) 90 2009 80 70 60 50 40 30 20 10 0 January February March April May June July August September October November December 2010 2011
Source: RDC Aviation 2011
Figure 2 Capacity trends in intra-European air travel
This overall growth however is expected to slow down in late 2011 and early 2012. First indications of that effect emerged even before the demand slow-down became apparent. Industry estimates for 2012 and 2013 from as early as Q1/2011 forecasted capacity expansion to ~3% per year. Still, despite the expected capacity corrections for 2012, Q3/2011 analyses warn of potential overcapacity problems in the near future15: Following recent significant corrections in demand growth, IATA expects difficulties in preventing capacity growth from a possible overshooting demand in 2012.
FSC data (short as well as long haul): AEA monthly traffic update, data from 8th November 2011 (http://www.aea.be/research/traffic/index.html); LCC data European Low Fares Airline Association, members' statistics December 2010 and June 2011 (http://www.elfaa.com/statistics.htm) 15 See http://www.bloomberg.com/news/2011-10-03/airlines-mired-in-crisis-as-margins-shrink-iata-chief-says.html, 3rd October 2011
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16
Only expanding LCCs on par with 2009 totals after 8 months

Intra-European ASK comparison
ASK's (billion) 350 2009 300 2010 2011 YTD
250
200
150
100
50
0 Low cost
Source: RDC Aviation 2010
Oneworld
Skyteam
Star Alliance
Other
Figure 3 Short-haul ASK year-on-year growth comparison of LCCs16 and FSCs
3.2.3
Supply Development in the Full Service Segment
European SH routes are still suffering from LCC stroke amplified by fragile economic conditions. Naturally, this influences the airlines' appetite for capacity expansion. Competition in the full service segment intensifies with ongoing consolidation driven by sustaining high number of many small- and midsized players in the region. This leads the overall development towards consolidation, the latest evidence being seen in mergers of City Airline with Skywards and Cimber Sterling and Meridiana with Air Italy. The European ASK growth is mainly driven by LH activity as FSCs concentrate most of their capacity additions on the significantly more profitable routes to high growth regions of Asia and America, with the means of which they fund their SH services used for LH connections. This hinges, long haul is the main revenue driver and accordingly all three alliances have been working on the LH part of their network lately. Therefore, in 2011 we could see IAG, Air France as well as Lufthansa being active in developing joint ventures between Europe, and Asia (similar to those that they already have with North America) in search for increased cooperation to help them improve offering, reduce costs and also deal with strict ownership rules on the foreign markets. Restructuring is the common picture we can see in many airlines. The commoditization of SH traffic in Europe combined with the constant pressure of LCCs as well as the difficult economic environment constantly pushes all airlines to restructure their operations. Much more efficient cost structure is needed to operate profitably especially on routes not feeding the main hubs. Although this holds for all FSCs, it affects mainly small- and mid-sized airlines that are not able to counter the LCC activities and miss
16
Includes Ryanair, easyJet, airberlin, Norwegian, Vueling, FlyBE, Wizz Air, germanwings and Thomson Airways
17
revenue from the LH operations. Additionally, the ongoing economic volatility caused the main FSC revenue source - business passengers - to increasingly search for travel in economy or even with LCCs. As a result, in the upcoming winter the majority of European carriers (FSCs as well as some LCCs) are planning to slow down their H1 2011 SH expansion in order to prevent potential losses stemming from the worsening economic outlook. 3.2.3.1 Profiles and Intentions of Key Players
The Big 3: Lufthansa, IAG and Air France-KLM Lufthansa: Lufthansa group currently spends a lot of effort to restructure their group members. The success of the activity can be seen in Swiss being the strongest business in the group, delivering solid performance of 16% increase in revenue over the first three quarters of 2011. On the other hand, the restructuring efforts do not bring rewards so far in Austrian Airlines. The group is also assessing to sell some of its parts (namely, the sale of bmi is strongly discussed these days). Despite some success with restructuring, weaker than expected year-on-year performance in short haul and ongoing European economic uncertainty made Lufthansa continuously scale down its growth plans during 2011. Although the airline is currently not expecting economy to slip into a double dip scenario, latest data including the forward bookings profile make the group reassess its SH plans17. On intra-European routes, apart from continuing aircraft seat densification, Lufthansa has gradually decreased the 2012 SH growth from 12% (planned at the end of 2010) to mere 4% (in autumn 2011). In the long haul, Lufthansa lately received antitrust approval to form a joint venture with ANA, another Star Alliance carrier. If concluded, this would be the first agreement of such a kind between the two regions. IAG: Being formed by the merger of British Airways (BA) and Iberia at the start of this year, the IAG management is currently focused on realizing synergies from the combined company. The latest most noticeable strategic move is the planned launch of new Spanish LCC called Iberia Express in summer 2012. IAG's motivation is to face LCC competition on some of Iberia's current loss-making short- and midhaul routes as well as it is to create new feeder services for its profitable LH routes. This continued LCC strategy (Iberia had also been using low service before through Air Nostrum and Vueling.) is also part of efforts of IAG to reduce the cost base of Iberia and return it back to profitability. Further, BA is also motivated in purchase of bmi carrier from Lufthansa to densify its short haul feeder network and strengthen its position on London Heathrow airport. On the long haul, IAG is also reviewing its services between Europe and Japan, which are currently codeshared with oneworld partner JAL. The intention is to create a joint venture, similar to the current cooperation with American Airlines on trans-Atlantic routes. Air France-KLM: Being strongly restricted by the union pressure, Air France could not face the SH situation with a new LCC subsidiary like IAG did. The latest strategic efforts aim to solve the problems of its SH segment with these two measures: 1. Increasing the activity on the mid-haul routes: Focusing on point-to-point traffic from French provincial cities (these destinations have been put aside during the latest process of post merger integration with KLM). The ambitious objective of this new Air France strategy is to develop the
17
Source: CAPA Centre for Aviation (http://www.centreforaviation.com/analysis/lufthansa-earnings-fall-27-asoutlook-deteriorates-further-61765, 1st November 2011)
18
company's short and medium haul network and return to profitable growth while countering the LCC threat in its home market. As a result, Air France will add 54 new routes to destinations across Europe and the Mediterranean. This will lead to a 30+% increase in its regional capacity. 2. Implementing reduction measures in operating costs: The main focus is on improvements in labor productivity and fleet standardization to the A320 across all regional bases. Further effort is exerted to improve aircraft utilization aiming at a 40% increase. In addition, Air France intends to densify seats in its SH fleet. The combined effect should enable the airline to start their low fares offers at price levels competitive to LCCs. On the long haul, the carrier aims to cooperate closely with a partner such as Korean Air and/or China Southern and China Eastern. CEE FSC Airlines: CSA, LOT, Malev and others The CEE region is expected to see a wave of privatizations as the state-owned regional airlines are looking for partners to help them overcome the effects of current economic situation resulting from past and currently looming financial crisis. Most of the airlines suffered losses both in 2009 and 2010 and are currently undergoing restructuring to varying degrees that should prepare them for upcoming privatization. All FSC carriers based in the region focus their restructuring efforts on re-positioning and cost cutting. As a result, the fleets are being scaled down, unprofitable routes closed and strong pressure is being put on operating expenses (decreases in staff headcount, operations optimization). Potential investors include current European airline alliance leaders (IAG, AF-KLM and Lufthansa) as well as major Middle East airlines seeking to secure their way to access the European markets. Apart from the existing slots at main airports, the airlines offer mainly cost advantage of CEE country (compared to West European price levels) and the strategic position of home airports. Their bases are usually situated between CIS, Western Europe and Middle East, which represents an advantage that is further supported by existing bilateral agreements with former Soviet Union countries. CSA Czech Airlines: CSA is the Czech national carrier based in Prague (Ruzyne Airport), the majority share is currently controlled by the Czech Republic government. The airline is a member of Sky Team alliance and operates short- and mid-haul network of scheduled passenger services mainly within Western Europe, CEE and CIS regions. The airline is currently finishing its restructuring process that downsized the fleet and FTE counts with the main intention to make it more attractive for new potential investors. Although the new business model does not use LH it relies on existing bilateral agreements with CIS countries combined with strategic position of Prague airport two things that predetermine CSA to focus on sixth-freedom traffic between CIS and Western Europe. However, the current set-up makes CSA also susceptible to economic downturn as well as to LCC pressure as the catchment area of the home market is relatively small and generates neither sufficient business nor long haul traffic demand. Additionally, this market is rather price sensitive favoring further LCC penetration. LOT Polish Airlines: The national airline of Poland based in Warsaw is majority-owned by the Polish Government. The airline operates a network of short and long haul routes within Europe and to North America and the Middle East focusing mainly on traffic from Warsaw airport (~85% of routes from/to Warsaw). The LOT Polish Airlines is a member of the Star Alliance. After a few years of search for a strategic partner for LOT, the Polish government is now aiming to find a strategic investor in 2012. The company recently underwent restructuring focusing on network optimization as well as cost control, and the privatization is the main focus of the current management. The
19
most recent LOTs strategy is also to better leverage the geography and focus on sixth freedom operations between Eastern and Western Europe as well as try to penetrate underserved East European LH markets. LOT is considered to be less vulnerable to the economic cycle as the home market offers sufficient business traffic potential together with sufficient LH demand. On the other hand, LOT has to defend its home market against pressure exerted by LCCs, especially Wizz Air and Ryanair (recently announced further expansion in this direction). Malv Hungarian Airlines: The carrier is the national airline of Hungary. Based at Budapest Ferihegy International Airport, the carrier offers scheduled services on short- and mid-haul routes to destinations covering Europe, CIS, and the Middle East. Malv is a member of the oneworld alliance. Currently being fully state-owned, the airline was re-nationalized in early 2010, when the Hungarian State acquired back 95% of the airline's equity from the former majority shareholder. However, the government has again made its openness to privatization public, yet this time it prefers a strategic investment of another larger carrier. After the restructuring in 2010, the airline is focusing more on steady business traffic demand giving up on seasonal leisure routes seized by LCCs, especially Wizz Air. Combined with the size of the home market, this puts the carrier into a situation similar to CSA being while more threatened by potential negative economic development. Other CEE airlines: Other airlines in the region are in very similar positions to the three carriers described above. They all struggle with increasing exposure to low-cost carriers, with the necessity to solve excessive debt obligations and the need to find a potential strategic partner.
Adria Airways. The sole shareholder, Slovenian government, has announced that it will begin the privatization process in March 2012 at the latest. Experts believe the Slovenian national carrier could attract interest from Qatar Airways, Emirates and the Air France-KLM group. In September 2011 the airline started downsizing to cut their losses and improve its financial position. Jat Airways. The Serbian government announced another tender for the sale of this Serbian national carrier in August 2011. However, this offer, that follows the previous failed attempt to sell the majority stake in the airline to Turkish Airlines in 2010, has generated little interest so far. TAROM. IMF lately changed its position of the Romanian national carrier privatization and insists on the full privatization instead of a stock exchange listing (planned sale of a 20% government owned stake). However, due to 2010 losses that amounted to nearly EUR 80 M, TAROM first needs to take strategic measures to cut down the costs and to undergo restructuring before its sale. Montenegro Airlines. The Montenegro government made a second attempt to privatize the national carrier in September 2011. This follows an unsuccessful attempt to sell a 30% share in 2010. El Al Israel Airlines, Etihad Airways and Arkia Israel Airlines all purchased the 2011 tender documentation but none of them made an offer. Development in the Low Cost segment
3.2.4
The growth picture for LCCs is rather different to that of FSCs: in the period between 2004 and 2008 LCCs' market share gain was of astonishing 35+% CAGR, while FSCs' were relatively flat at ~4% CAGR. LCCs finished 2010 with strong 38% intra-European passenger market share and still grew strongly in 2011 especially in the summer months, riding on the wave of leisure travel. Building on their recent performance, LCCs are expected to account for around 43%-50% of the intra-European market in 2020. Yet, short-term fluctuations are not avoiding LCCs either, as easyJet announced zero growth for this winter and Ryanair even 4% capacity cuts.
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As opposed to FSCs, LCCs use their cost advantage to achieve very high load factors with the ability to flexibly adapt their prices. In 2011 easyJet reported 90% and Ryanair 85% load factors, drastically outperforming their FSC peers. Despite high fuel costs, LCCs are still able to maintain the cost advantages over FSCs (mainly low cost platforms and higher productivity) as shown in the Figure 4 and Figure 5 below. Despite the growth of the LCC segment, the rising input costs and the weak economic outlooks pushed even the main LCCs like Ryanair and easyJet to mind yields. As a result, we saw LCCs implementing more ancillary revenue projects, making changes in their networks and even cutting capacities.
Significant cost gap remains between FSCs and LCCs
2009/10 CASK ex-fuel on European network3

cts
11
AF
10 9 8 7 6 5
KL
LH
BA IB
U2
4 3 2 1 0 0 1 000 1 200 1 400 1 600 Average stage length (km)

1."iso-cost" lines drawn with 60% fixed costs and 40% variable costs 2. Calendar year data for IB and LH, IATA year for AF, KL and BA 3. Routes excl Israel, incl. North Africa Source: PR.IE., AEA
Subsidies 1 to 2 cts
FR
Figure 4 Cost variances between FSCs and LCCs
LCCs utilize planes better: 60% higher "airtime" and 50% more passengers on board than FSCs
Airtime
12 24
Number of seats and utilization

23 13
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FED WC Galley
Sold seats hours/day
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5 1.5 = 7.5 hours D Productivity +60% 8 1.5 = 12 hours

12 11 1 23 2 22 24 13
84 sold seats +19% +25% +140%
126 sold seats

4
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1 CB A
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1. Typical flag carrier 2. Low-cost carrier Source: BCG analysis
Figure 5 Sources of LCC advantage
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3.2.4.1
Profiles and Intentions of Key Players
Ryanair: The Irish-based LCC recently announced plans to cut the capacity in upcoming winter season. This is the first capacity cut, in the company history. Additionally, 25 new aircraft received by Q1 2012 will not be put into operation until April 2012. The carrier is focusing its closest growth ambitions on Central Europes secondary airports (currently strengthening its presence in Poland) as well as it is analyzing its possibilities on Nordic markets that are now dominated by the booming Norwegian (which continues to strengthen its position). On the other hand, the plan is reduce the market presence in France and Germany. The LCC is solving the longer-term issue of whether it will keep its focus on growth or instead stop buying aircraft and focus on profitability (as the carrier currently cannot find a deal with suppliers on buying new aircraft). Such strategic re-positioning would have a huge impact if it actually happens. easyJet: The UK LCC plans to leave capacity flat in upcoming winter 2011 after a few years of expansion. The LCC is these days focusing on intensification of its expansion in the French market planning to start several more bases in the country from summer 2012. France is currently seen as strongly underserved by LCCs compared to other Western European countries as the LCC PAX share reaches only 24%. Wizz Air: This Hungary-based largest CEE low budget airline is on a growing trajectory, recently opening new bases in Lithuania and Serbia. The company expects the CEE region longer-term performance to develop as travel needs of region shall become more like those of the EU15. Wizz Air targets also the CIS region but is strongly limited by regulatory hurdles (except small Ukrainian market mainly with flights to Kiev and Lviv). Additionally, the overall growth expectations of Wizz Air are supported by the fact that the current fleet of 34 aircraft is just a part of the full A320s order according to which 132 planes are to be gradually delivered until 2017. Air Berlin: The Germany-based LCC currently struggles with its profitability and is therefore focusing more on its restructuring Shape & Size program instead of future growth. Forced by the groups unfavorable results of last years, not only that the LCC does not expect any further expansion, but the current plan is to re-assess existing network and even cut its capacity by selling or returning leased planes. Norwegian: This Norwegian LCC has been growing with in recent years an impressive rate of ~25%. Along with the expansion, the airline focused also on modernization of its fleet that now represents the key driver of its low unit cost. Although increasing resistance is expected both from major regional rival SAS and main LCC competitors like Ryanair, we expect the carrier to continue its double digit growth also in the next years, focusing among other areas also on the CEE markets. 3.2.5 CIS market Supply
The strongly regulated Russian market is still awaiting its extensive consolidation, as Federal aviation regulator Rosaviatsia currently lists ~150 airlines in Russia. The largest player - state owned Aeroflot - is already in the process of gaining control over six other state owned air carriers (ex-Rosavia assets) thereby looking up to absorb additional 50% of PAX. Other airlines are growing organically (e.g. Transaero, S7, UTAir) and, even though Russia's international air travel market remains governed by bilateral agreements from the 1960s, many short- and LH connections have recently been opened13. The market liberalization which would open CIS countries to competition and thereby a wave of LCC entries remains a live topic in the region. Recent development shows however, that protective standpoint of local authorities is likely to continue to hinder the process. Ukraine is an example, where the prospect of signing the Open Skies Treaty seemed realistic in the beginning but the process has ground to a halt, after a government announcement calling for revision of all previously signed agreements related to Open Skies.
22
Concerning LCCs, the Russian market itself still remains underpenetrated despite its potential that is further amplified by growing demand for SH travel. The factors limiting LCCs prosperity are mainly the protective regulatory environment, less prepared infrastructure and surprising efficiency of inland FSCs such as Aeroflot18. The latest evidence of complicated environment is the recent demise of LCC Avianova leading to the situation in which the LCCs are virtually not present in the market with less than 5% market share. Moreover, as the only LCC in the Russian market currently remains the Sky Express airline, no LCCs are currently expected to gain stronger share in the region, in near future. 3.2.6 Future Supply Development
Apart from the ongoing seat densification, the future supply development of the market depends strongly on planned aircraft deliveries. We assume that especially full service carriers are not able to fully flex their capacities in the short-term, due to being able to manipulate only with small flight schedule adjustments. LCCs on the other hand have more space to manage their capacity owing to their business model. All in all, capacity growth of around 3% is expected (based on current orders in the ACAS airline aircraft database) in the next 1-2 years. In the mid-term we expect even full service carriers to be more flexible and to be able to potentially negotiate aircraft delivery postponements or sell some of their aircraft to manage their capacity offer. Therefore, carriers will be in this time horizon able to better manage the lasting gap between demand and supply growth and thereby prevent additional yield pressure. This is especially important for SH-only FSCs that do not have long haul to subsidize SH routes and for which any decline in yield represents a significant threat (additionally to current strong LCC price pressure). 3.3 External Factors
This section is devoted to two main external factors that affecting airline business prices of fuel and airline airport and navigation costs. Prices of fuel will certainly remain one of the most watched figures in the airline industry, as this item grew quickly over the last two years and it has reached to around 30% of carriers budgets. Unsurprisingly, large uncertainty exists over the development and effect of fuel prices in the near future. This is amplified by the hedge positions of individual airlines. 3.3.1 Fuel Costs
The price of fuel is certainly one of the most watched figures in the airline industry of today. During 2010, jet fuel prices rose from 88 USD/bbl. to 107 USD/bbl. by end of year. The average price of 91 USD/bbl. meant a jump of almost 30% compared to 2009. IATA estimates that the airline industry fuel bill rose to escalate to 26% of operating expenses. Year 2011 did not mean any change to this trend. Driven largely by unrest in the Middle East, prices quickly mounted up to 130 USD/bbl., which corresponds to around 33% of operating costs (according to IATA estimate). Large uncertainty exists over the development of fuel prices in the near future. Most hedges unwind at the end of this year and the start of 2012, exposing airlines to fuel prices forecasted at around 1040 USD/t19.
18
19
Source CAPA Centre for Aviation (see e.g. http://www.centreforaviation.com/analysis/russia-can-lay-claims-tobeing-one-of-the-worlds-most-dynamic-air-transport-markets-57461from 19th August, 2011; http://www.centreforaviation.com/analysis/avianova-bankruptcy-spotlights-instability-in-alluring-emerging-markets60121 from 7th October 2011) Median value of 15 investment bank reports, calculated from data available on 24 th October 2011
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3.3.2
Airport and Navigation Costs
According to IATA, the airport and navigation costs constitute the third largest cost bucket for airlines after fuel and labor, representing 11% of 2008 budgets. Airport and navigation charges have been ascending at faster rate in 2009, and in 2010 have reached up by 20% since 2006, AEA reports 20. Generally, airport costs are lower for LCCs, which purposely choose secondary airports for their flights to save on airport fees. This strategy has proven to be successful, as they were able to stimulate demand and attract a new segment of travelers and turn non-customers into frequent flyers. The navigation costs are the same for LCCs and FSCs (they go by aircraft size) but since LCCs have more condensed aircraft they split these costs among larger number of seats. However, big FSCs like AF, IAG and LH are these days increasingly deploying larger and more condensed aircraft with slim seats, thus narrowing the gap in unit costs. 3.4 Yields
Real passenger yields have been continuously decreasing with a CAGR of -2.5 to -3.0% since the early 1990s (European total) driven mainly by marked drop in SH yields, shown in Figure 6. The rate of decline in the crisis year of 2009 even accelerated to -11% p.a (-12% in short haul). Yet, this development was reversed by demand growth outpacing supply both in 2010 and 2011. Overall European real yield improved by 2% in 2010 with a slower downturn of -7% in short haul. IATA expects a "modest decline" in the year ahead as well. Hence, in the first quarter of 2011, the trend detected across the main European airlines was a slight decline vis--vis 2010, while only Aer Lingus and SAS reported a notable development in their Q1 yields. Interestingly, even LCCs such as AirBerlin and Vueling showed moderating yields in this period.
Long haul real yields growing in 2010 making long haul in 2011 more interesting than short- and mid-haul
Europe in 2010: LH yields growing by 9%, while SH yields continue to decline
Real yield (cUSD/RPK) AEA carriers 16 14 12 10 8 6 4 2003 2004 2005 2006 2007 2008 2009 2010 Short haul yield Aggregate yield Long haul yield Y-o-y change '09-'10 -7% +1% 10 Short haul / mid haul
European carriers in 2011 focus on long haul LH ASK growing faster than SH/MH
ASK, Y-o-Y growth (%) AEA carriers 15 Long haul
+9%
-5 2003 2004 2005 2006 2007 2008 2009 2010 2011 I-VIII
Traditional FSCs focusing more on LH rather than SH that is affected by drop of yields caused by economic situation and competition
Source: AEA data, BCG analysis
Figure 6 Short haul vs. long haul yield and ASK
20
Challenges Facing The European Airline Sector, AEA presentation, 5th October 2011
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4 Development Scenarios for 2012-2015
The purpose of this chapter is to describe the two European air market development scenarios set forth in this study. After providing basic overview of the scenario construction logic we devote a section to each of the scenarios and describe them in detail. For each scenario we give an overview of assumed input and resulting output parameters and also outline the expected impact of the given scenario on the market including the key clusters of airlines. As mentioned, the study sets forth two scenarios as follows: The Growth and The Low Growth Scenario. They describe the boundaries within which we assume the European short- and mid- haul market should evolve in the period until 2015. The scenarios combine assumptions on air traffic demand and supply with those on competitive situation in order to derive anticipated developments in traffic volumes and yields. For scenario construction logic see Figure 7 below - a combination of following six elements was used to define the two scenarios and formulate the key implications:

Macro environment Demand development and demand correction factors Supply development LCC progression Exogenous costs Yield levels
Scenario construction approach focuses on key drivers

Demand, yield and costs can be used to update airline business plans
Demand corrections
Effect of high speed trains on demand (%, '11-'15) Use Eurocontrol effects, correct by GDP development
Hi: current estimates Lo: effect stronger in '12 and '13
Macroeconomics
Parameter& calculation
Real GDP growth '11-'15 Use current forecasts and adjust by recession estimate Hi: current estimates Lo: recession in '12 and small recovery in '13
Yield
Yield development '11-'15 Use actual trend in yields correct by LCC development, supply demand gap and cost factors Hi: current corrected estimates Lo: yields lower in '12 and '13
Scenarios
Demand
RPK, PAX development '11-'15 Use IATA 2010 forecasts, correct by Eurocontrol expectations and GDP growth Hi: current corrected estimates Lo: demand lower in '12 and '13
LCCs
LCC share growth '11-'15 Use current LCC share + latest dynamics and combine with high and low growth scenarios from existing 2020 study Hi: 42% share by 2015 Lo: 45% by 2015
Parameter & calculation
Costs Supply
ASK development in '11-'15 Use currently estimated ASK forecasts, correct by latest info, effect of LCCs and demand Hi: current corrected estimates Lo: supply lower in '12 and '13 Change in key flight related cost elements (fuel, ETS, airports) in '11-'15 Use fuel forwards, ETS & tax effect estimates Hi: fuel flat in '12-'15, full effect of ETS and taxes Lo: fuel at 85% in '15, no ETS or tax effect
Scenarios
Key determinants of airline performance
Figure 7 Approach used for definition of the scenarios
25
Recent developments illustrate the uncertainty surrounding the near term economic outlook, and also the high volatility implicit in key economic indicators. In this context, it is worth stating that the European air transport market might react past the boundaries described in this document, as the future development of the European economy is extremely volatile at the time of drafting this document. Additionally, both scenarios do not anticipate any major shift in the current business model of large FSCs as they depend on the cross-subsidies between loss-making SH operations and profit-earning LH businesses. In the current context, this business model may be put at risk, in the medium term, by the competitive pressure of lower/higher service cost of Middle Eastern carriers, and efficient restructuring of North American carriers. The scenarios also do not operate with a possible market withdrawal of any major airline, which would certainly have a major impact on the European airline market as a whole. We also took the assumption that carriers will not pass projected fuel price increases onto customers (i.e. will not raise yield). The Growth Scenario assumes a mild upturn in 2012, which will then strengthen in 2013 and 2014, accompanied by moderate penetration of LCCs in key European markets. This should result in overall relatively lower rate of yield decline. The Low Growth Scenario assumes a demand dip in 2012 and a strong reinforcement of LCCs market position. LCC-driven yield pressure combined with expected high oil prices would consequently have a stronger impact on FSCs. 4.1 Scenario 1: Growth
The Growth Scenario assumes that 4Q 2011 recession warnings would only result in a slow-down in 2012 and Europe would return to the growth trajectory from 2013 onwards at growth levels originally forecasted in 2010. This scenario assumes real GDP growth between 1.5% and 2.5% p.a., with a corresponding air traffic demand growth of 3.5% p.a., despite the external growth-hindering factors such as high-speed train competition. To elaborate LCCs will be, the main driver that will get ahead with their market share by 1% p.a. to amount to 42% PAX share by 201521. Air traffic demand in the CIS region is assumed to grow by 3 to 8% p.a.22 On the supply side, market capacity is assumed to grow by 3% p.a. driven by LCCs that would go up by 6%. As for the CIS market, this scenario assumes that European FSCs would gain a fair portion of the projected growth. Additionally, successful LCC entry into the CIS market is not assumed, arguing that LCCs are still not competitive in comparison with established carriers in terms of right possession traffic and also considering the current regulatory environment of the CIS markets. Following, the possible slower growth of the LCC market alleviates the pressure on yield. On that account, higher fares would allow the industry to absorb the effects of ETS and travel taxes and thereby prevent further negative impact on demand. It should be noted that our overall market model is based on the assumption that carriers will not pass the projected fuel price increases onto customers, i.e. will not increase yield. (For impact of the Growth scenario see Figure 8 and Figure 9 below) Table 2 below gives a comprehensive overview of Growth scenario parameters.
21
22
Corresponds to base growth scenario in Market Share of Low Fares Airlines in Europe, ELFAA and York Aviation Report, see http://www.elfaa.com/documents/LFAs_Market_Share_YorkAviation.pdf Based on IATA Airline Industry Forecast 2010-2014, see http://www.iata.org/ps/publications/pages/airline-industryforecast.aspx
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Table 2 Parameters of The Growth scenario
Parameter
Real GDP growth Inflation Exchange rates Europe EU - of that CEE CIS EUR/USD PAX volumes intra-Europe - of that intra-W. Europe - of that CIS - W. Europe - of that CEE - W. Europe - of that CIS CEE Effect of trains etc. PAX market share Short haul ASK growth Short-haul yields Jet Fuel USD/t
2011P 2012F 2013F 2014F 2015F

2.4% 2.7% 5.0% 9.6% 1.39 5.0% 2.5% 5.8% 3.2% 8.9% 0.1% 38% 6.5% -5% 876 1.5% 1.9% 4.2% 8.0% 1.27 2.0% 1.4% 2.8% 3.0% 3.7% 0.1% 39% 3.0% -3.7% 988 2.3% 1.9% 3.7% 7.0% 1.29 3.5% 3.0% 5.6% 6.4% 6.9% 0.1% 40% 3.5% -2.5% 1 042 2.3% 1.9% 3.5% 6.4% 1.32 4.0% 3.5% 6.0% 6.7% 7.4% 0.2% 41% 3.5% -2.8% 1 042 2.5% 2.0% 3.4% 6.1% 1.34 4.5% 3.9% 6.7% 6.7% 8.0% 0.2% 42% 4.0% -3.0% 1 042
Demand
Demand correction LCCs Supply Real Yield Costs
4.2
The Growth Scenario Impact FSC Short haul: difficult 2012 followed by a slow recovery in 2013-2015 RPK and ASK going up at +2% p.a., yet the positive development of RPK is slower in 2012 and only picks up in 2013. Along this, FSCs will be not able to cut capacity fast enough in 2012 and will therefore see a drop in average SLF amounting to ~1.5pp in 2012. Due to demand recovery and FSC capacity adjustments in 2013, SLF will be flat in 2013 and later grow by 1pp p.a. in 2014 and 2015. The drop in RPK in 2012 will be accompanied by FSC real SH (SH) yield downturn (-4%). The rate of real yield decrease slows down to stay in the region of ~-2% (i.e. nominally flat at 2% inflation) in the 2013-2015 period. It will be only the CIS-Europe traffic growing fast, with an average positive development of 5.3% p.a. We expect the CIS markets to stay strongly regulated and protected against LCC entry, which should help especially the smaller CEE carriers to bear the general yield pressure. Advancing price of fuel combined with drop of USD/EUR FX rate will then exert pressure on airline CASK in 2012. Despite the cost-cutting efforts (nominal CASK ex fuel expected to go down by -1% p.a.) we expect an increase of CASK in 2012 by 4% and a slow descend in 2013-2015. We expect RASK to decrease by 3% in 2012 due to the lower demand that will not be matched by FSC supply. RASK will remain flat later as the demand recovers and FSCs will adjust their supply to the demand in the longer run. As a result of the above, FSC SH profitability will continue to suffer in the observed time period unless the FSCs embark upon deep structural changes. We expect that the big FSCs 27
with LH routes (Air France, IAG, Lufthansa) will continue to cross-subsidize their SH feeders and to restructure their cost base. Within this process, they will continue re-arranging their networks with the focus on the most profitable routes, leaving less interesting routes to the LCC competition. Therefore, we do not expect them to open many new connections (with the exception of adding routes to CIS region) but rather to intensify traffic on existing feeder routes. Meanwhile, smaller CEE airlines (e.g. CSA, LOT or Malev) will finish their restructuring process and continue relying on the east-west traffic. However, their strategic direction might be strongly influenced not only by success of the restructuring but also by the results of the potential privatization and the new strategic partnership. We expect the main currencies in the region (CZK, HUF and PLN) to appreciate. This will slightly release the pressure of fuel prices but might cause complications on the side of the revenues and operational expenses which emphasize the need for successful restructuring.
LCCs: Achieving Reasonable Growth in 2012-2015 Flexibility of the LCC business model will allow carriers to accommodate their capacity to the demand and we will see both RPK and ASK growth by 6% p.a. Real yield of LCCs will continue to descend by -1% p.a. driven by pricing strategies enabled by their cost advantage over FSCs. The escalating fuel prices in 2012 will hit LCCs stronger than FSCs. For this reason, their unit costs will increase by 8% over the next 2 years, and then slightly cutback at -1% p.a. As LCCs already operate on high enough efficiency levels, we do not expect to see them cutting their ex-fuel CASK On the other hand, the strong demand for LCC services will drive their RASK up at a rate of 1% p.a. As a result, the LCC segment will stay profitable also in 2012-2015 despite expected general decrease in PAX traffic profitability. Though, some margin pressure may be felt. Additionally, as the growth stalls, LCCs are going to find it harder to preserve their performance rates. In this context we might expect LCCs pushing stronger on their two basic strategies: 1. Moving to marginal markets where had been no prior air service usually stimulating demand. 2. Moving to key markets, trying to capture some share from the mainline. Obviously, the second model is going to be more damaging for FSCs and therefore will make it even more complicated for the FSCs to get back to profitability on their SH routes.
28
Growth scenario: LCCs growing stronger than FSCs

FSC capacity and demand growing by 2% p.a., LCCs growing by 6% p.a.
FSC SH demand and supply

FSC ASK and RPK (indexed to 2011)
130
LCC demand and supply

LCC ASK and RPK (indexed to 2011)
130 ASK +6% 7.6 RPK
Real SH yields
Real yield (cEUR/RPK) -2%
9.5 9.2 9.0 8.7
8.5
125 120
125 120
7.3
7.1
6.9
FSC SH yield -3% Real SH yield -3%
6.7
115 +2% 110 RPK ASK +2% RPK 100 2011 SLF change (pp) 2012 2013 2014 2015
115
4.5
4.5
4.4
4.4
4.3
110
LCC yield -1%
105
ASK
105
100 2011 2012 2013 2014 2015 2011 2012 2013 2014 2015
-1.5
+0.1
+1.0
+1.0
0.0
0.0
0.0
0.0
Source: BCG analysis
CAGR 2012-2015
Figure 8 Growth Scenario: Demand, supply and yield development
Growth scenario: FSCs CASK cuts lag behind RASK decline

Effect of increased fuel prices offset by cost cutting (FSC) and PAX revenue increase (LCC)
Nominal FSC unit cost & revenue

FSC SH RASK & CASK (indexed to 2011)
110
Nominal LCC unit costs & revenue

LCC RASK & CASK (indexed to 2011)
110
CASK +2% 105 -0% 105
RASK (PAX reve)

+1% 100 CASK ex fuel 0%
CASK
100 -1% RASK (PAX reve) 95 2011 2012 2013 2014 CASK ex fuel 95 -1%
2015
2011
2012
2013
2014
2015
%
CAGR 2012-2015
Figure 9 Growth Scenario: Unit costs and revenues
29
4.3
Scenario 2: Low Growth
The Low Growth scenario assumes a short and mild -1% recession in Europe in 2012 followed by a recovery to 1.5% growth in 2013 and a slow return to GDP growth thereafter. The assumed real GDP dip accompanied by lower consumer and business confidence would slow the air traffic growth down to 1% 3% p.a. Consequently, the lack of business and consumer confidence would favor LCCs as the cheaper transportation alternative. For this reason, the Low Growth Scenario assumes LCC PAX share to amount to 2% p.a. resulting in 2015 market share of 46%23. Accordingly, faster LCC penetration would the principal driver of SH LCC yield decline at -3.7% p.a. This scenario assumes that CIS economies would still be hit by the European recession (although less than in the Growth Scenario), leaving PAX growth between 1.5% and 6.5% p.a. However, we assume in this scenario, that CIS passengers as well as protectionist regulatory environment will favor their own CIS airlines leaving European competition flat on PAX growth. On the supply side, it is assumed that FSCs would not succeed in fully adjusting their SH capacities leading to adverse effects on SLF. To counter this, FSCs would lower prices and thereby contribute to faster yield decline. As for Russia and CIS, this scenario assumes that Russian airlines would exploit the temporary weakness of European FSCs and open new routes to Europe in order to capture far above their fair share of market growth. Again, we took here the premise that carriers will not pass projected fuel price increases onto customers, i.e. will not raise yield. As a result, those FSCs that have the LH option would rely on LH traffic supported by continuing growth in Asia while those that are SH only would suffer greater losses. (For impact of the Low Growth scenario see Figure 10 and Figure 11 below) Table 3 (below) gives a comprehensive overview of Growth Scenario parameters.
Table 3 Parameters of the The Low growth scenario Parameter Real GDP growth Inflation Exchange rates Europe EU - of that CEE CIS EUR/USD PAX volumes intra-Europe - of that intra-W. Europe - of that CIS - W. Europe - of that CEE - W. Europe - of that CIS - CEE Effect of trains etc. PAX market share Short haul ASK growth Short-haul yields Jet fuel USD/t 2011P 2.4% 2.7% 5.0% 9.6% 1.39 5.0% 2.5% 5.8% 3.2% 8.9% 0.1% 38% 6.5% -5.0% 876 2012F -1.0% 1.9% 4.2% 8.0% 1.27 1.0% 0.7% 1.4% 1.5% 1.8% 0.1% 41% 2.5% -5.0% 988 2013F 1.0% 1.9% 3.7% 7.0% 1.29 1.5% 1.3% 2.4% 2.8% 3.0% 0.1% 43% 3.0% -4.6% 1 042 2014F 1.5% 1.9% 3.5% 6.4% 1.32 2.6% 2.3% 3.9% 4.3% 4.8% 0.2% 45% 3.0% -2.6% 1 042 2015F 2.0% 2.0% 3.4% 6.1% 1.34 3.6% 3.1% 5.4% 5.4% 6.4% 0.2% 46% 3.5% -2.1% 1 042
Demand
Demand correction LCCs Supply Real Yield Costs
23
Corresponds to high growth scenario in Market Share of Low Fares Airlines in Europe, ELFAA and York Aviation Report, see http://www.elfaa.com/documents/LFAs_Market_Share_YorkAviation.pdf
30
4.4
The Low Growth Scenario Impact FSC SH: Difficult 2012 and 2013forcing FSCs to undergo structural changes combined with gradual retreat from SH routes Recession in 2012 to drive demand down and cause RPK to decline by 2% p.a. in 2012 and 2013. After that, we expect that economic recovery will prevent further downturn and drive PAX up causing demand to go flat in 2014 and to grow in 2014 and 2015 (~+1% ) FSCs react and cut their ASK in 2012 by 0.5% and in 2013-2015 at the average speed of 1% p.a. leaving the whole European SH market capacity increase to be driven by LCCs ASK cuts are too slow in 2012 and 2013 resulting in an average SLF decline by ~1.5-2 pp each year in that period. SLF will follow demand and start to recover in 2014 and improve by 0.5-1.5 pp p.a. in 2014 and 2015. The cutback in demand in 2012 and 2013 will be accompanied by FSC real SH yield drop (4% p.a.), the rate of decline of the real yield then slows down to stay in the region of ~-1.5% during the recovery in 2014 and 2015. Growing price of fuels combined with appreciation of the USD will exert the pressure on airline CASK. Therefore, we expect elevation in 2012 CASK by 4%. Additionally, the upturn of the CIS market traffic will be absorbed by CIS airlines leaving European FSCs flat in terms of RPK. The CASK growth in 2012 will force FSCs to focus even more on cost cutting and reach CASK ex fuel decrease of -2% p.a. This will lead to CASK improvement in 2013-2015 in 2015 we will see CASK at 98% of 2011 level. As a result of the drop in demand, RASK will decrease by 7% in 2012-2013 but will recover in 2014-2015 as demand picks up and FSCs adjust their supply to lower demand in the longer run. The described development will cause SH profitability to suffer in 2012 and 2013 and start to recover earliest in 2014 and 2015 as FSCs will undergo structural changes: among other measures they are expected to also accommodate their networks to the new market situation and leave their less profitable SH routes to LCCs. We expect that the big FSCs with LH routes (Air France, IAG, Lufthansa) will slowly scale down traffic on their SH feeders while strengthening efforts to restructure their cost base. New aircraft will be used mainly to support traffic on existing feeder routes. Meanwhile, smaller CEE airlines (e.g. CSA, LOT or Malev) will finish their restructuring processes and continue relying on the east-west traffic. However, their strategic direction might be strongly influenced not only by the success of the restructuring but also by the results of the potential privatization and new strategic partnership. We expect the main currencies in the region (CZK, HUF and PLN) to appreciate. This will slightly release the pressure of fuel prices but might cause complications on the side of revenues and operational expenses which emphasizes the need for successful restructuring. LCCs: Driving the European SH market growth in 2012-2015 Flexibility of the business model will enable FSCs to adjust their capacity to demand. As the customer interest for LCC travel will be even amplified by economic recession in 2012, we will see both RPK and ASK grow by 7% p.a. Real yield of LCCs will continue to drop by 1% p.a. driven by pricing strategies enabled by their cost advantage over FSCs. 31
Same as in the Growth scenario, the growth of fuel prices in 2012 will hit LCCs stronger than FSCs. Their unit costs will shoot up by 8% in 2012-2013 and then slightly decline at -1% p.a. Again, we do not expect to see LCCs cutting their ex-fuel CASK as we think they already operate on high enough efficiency levels, not to be forced to go through cost-cutting, especially if expanding at +7% p.a. The strong demand for LCCs services will drive their RASK up at the rate of +1% p.a. which will help them to cover cost growth described above. Apart from the growth of pure point-topoint traffic, LCCs will profit from the FSC strategy to focus mainly on LH traffic and will slowly overtake a lot of feeder routes to main hubs. Also in this scenario the LCC segment will stay profitable in 2012-2015 despite the expected general decrease in PAX traffic profitability. Nevertheless, some margin pressure may be felt.
32
Low Growth scenario: LCC growth in SH accelerated by crisis

FSC capacity and RPK at 1% p.a. decline, LCCs growing 7% p.a.,
FSC SH demand and supply

FSC ASK and RPK (indexed to 2011)
135
LCC demand and supply

LCC ASK and RPK (indexed to 2011)
135 ASK RPK
Real SH yields
Real yield (cEUR/RPK)
9.5 +7% 7.6 7.2 9.1
8.8
8.6
8.5
130
125 120
130
125 120 115 110 105 100 95 2011 2012 2013 2014
6.9
FSC SH yield -4% Real SH yield -3%
6.7
6.6
115
110 105
4.5
4.5
4.4
4.4
4.3
LCC yield -1%
-1%
100 95 2011 SLF change (pp) 2012 2013 2014 ASK RPK -1% 2015
2015
2011
2012
2013
2014
2015
-1.9
-1.6
+0.5
+1.4
0.0
0.0
0.0
0.0
CAGR 2012-2015
Figure 10 Low Growth Scenario: Demand, supply and yield development
Low Growth scenario: FSCs with sharper RASK decline

FSCs reducing ASK and costs but not fast enough to offset RASK decrease in 2012-2013
Nominal FSC unit cost & revenue

FSC SH RASK & CASK (indexed to 2011)
110
Nominal LCC unit costs & revenue

LCC RASK & CASK (indexed to 2011)
110 CASK +2% RASK (PAX) +1%
105
105
100
-0% CASK
100
CASK ex-fuel 0%
95
RASK 95 (PAX reve) -1% CASK ex-fuel -2% 2011 2012 2013 2014 2015 90 2011 2012 2013 2014 2015
90
%
CAGR 2012-2015
Figure 11 Low Growth Scenario: Unit costs and revenues
33
5 Appendix: Scenario Reasoning
This chapter gives an overview of the key parameters, assumptions that were used in the market study and also the reasoning cementing them into a single cohesive whole. The following six groups of parameters were used to describe the possible development as shown in the Growth and Low Growth scenarios:

Macroeconomic factors (European real GDP growth, European inflation and USD/EUR rate) LCC progression (development of LCC passenger market share) Demand (realized passenger-kilometers) Supply (available seat-kilometers) Airline costs (development of jet fuel costs) Yields (real yields on European SH market)
Figure 12 (below) shows a comprehensive summary of the key assumptions made. Further in this chapter, a section is devoted to each of the parameters to explain the logic driving the assumptions. The scenarios do not consider a major change in the current business model of large FSCs that is characterized by cross-subsidies between loss-making SH operations and profit-earning LH businesses. We therefore do not account for the possibility that this business model may be fundamentally threatened in the medium term by the competitive pressure of lower cost/high service Middle Eastern carriers and efficiently re-structured North American carriers.
Airline market study: main assumptions

GDP growths: growth drop in 2012 (recession in Low Growth scenario)
Real GDP growth (%) 3 2 1 0 -1 2011 2012 2013 2014 2015 35 30
LCC PAX share: LCC gain higher share in Low Growth scenario
LCC PAX share (%) 50 45 40 Low Growth Scenario Growth Scenario
Economic assumptions (for both scenarios)1

FX rate (USD/EUR) 1.4 1.2 1.0 0.8 2011 2012 2013 2014 2015 Jet fuel USD/EUR Jet fuel (USD/t) 1,500 1,250 1,000 750 500
Growth Scenario
Low Growth Scenario
Demand growths: lower growth in Low Growth scenario

5 4 3 2 1 0 2011 2012 2013 2014 2015 RPK growth (%) Growth Scenario Low Growth Scenario
2011 2012 2013 2014 2015 Supply growths: lower growth in Low Growth scenario
Other assumptions for both scenarios

Inflation2 Weight of fuel costs in CASK Yields in 20114 LCC share on SH in 20113 LCC FSC SH LCC FSC SH 1.9% (yearly) 30% 20% 4.5 c/RPK 9.5c/RPK 38% 35%
8 6 4 2 0 2011
ASK growth (%)
Growth Scenario Low Growth Scenario 2012 2013 2014 2015
PAX
ASK
1.Jet fuel prices based on latest inv. bank reports (median scenario); EUR/USD based on latest inv. bank reports 2.Inflation: latest IMF forecast 3. Based on York aviation study (February '11) 4. AEA data and company reports Source: BCG analysis
Figure 12 Main parameters and assumption about their development
34
5.1
Macroeconomic Factors
The outlooks in both of the scenarios stem from IMF predictions with the adjustments based on the most recent information (EU information, investment bank reports). The general logic is that in the Growth scenario, the most recent IMF forecast is taken without further adjustments, while the Low Growth is simulating a more negative GDP growth outlook based on current indications. (For summary of GDP growth assumptions in both scenarios see Table 4 below)
Table 4 Real European GDP growth estimations
Scenario Growth Low growth
2011P 2.4% 2.4%
European real GDP growth 2012F 2013F 2014F 2015F 1.5% 2.3% 2.3% 2.5% -1.0% 1.0% 1.5% 2.0%
Avg. '12-'15 2.2% 0.9%
GDP in the Growth Scenario: In this scenario we expect real European GDP to go up by 1.5% in 2012 and then return to growth trajectory of ~2.3% p.a. the development that was already projected in 2010. Viability of GDP growth in 2012 is further supported by current business confidence values published by the EC. Although in decline, business confidence is still far from the levels of spring 2009, when EU27 GDP fell by -4.3%. GDP in the Low Growth Scenario: This scenario expects a mild recession in 2011 and a temporary slowdown in 2012 followed by a gradual recovery. It uses adjusted IMF figures that take into consideration the difference in business confidence levels between the time the forecast was published in and the current situation. Considering the past confidence and accuracy of IMF forecasts, we expect that actual real GDP should end up within 3 p.p. range of the latest IMF forecast (for instance: projections published at the time of the recession in spring 2009 underestimated the actual 2010 GDP growth by 2p.p., while spring 2010 projections did so by only 0.8p.p.). Additionally, clear downward trend in business confidence observed in the second half of 2011 may suggest yet another recession round. The current level however is still above spring 2009 levels and we do not see a reason to predict a worse than -1% real GDP decline. European inflation and exchange rates: Inflation forecast is taken directly from the ECB. The exchange rate forecasts, on the other hand, built on a combination of latest estimates from Bloomberg and investment banks adjusted by information from ECB, Eurostat, the IMF and the UN. Assumptions regarding the development of the two indicators are summarized in the Table 5 below.
Table 5 Estimations of inflation and exchange rates development
Inflation USD/EUR rate USD/CZK rate EUR/CZK rate USD/PLN rate EUR/PLN rate USD/HUF rate EUR/HUF rate
2011P 2.7% 1.39 17.6 24.5 2.97 4.12 218 291
2012F 1.9% 1.27 19.6 25 3.45 4.39 205 280
2013F 1.9% 1.29 18.8 24.1 3.13 4.03 208 270
2014F 1.9% 1.32 17.6 23.3 2.73 3.75 203 274
2015F 2.0% 1.34 16.7 22.4 2.59 3.43 200 270
Avg. '12-'15 1.9% 1.31 18.2 23.7 3.0 3.9 204 274
35
5.2
LCC Progression
The assumed LCC market share growth is based on a study recently published by York Aviation24. In both scenarios we expect that European LCCs will not gain access to CIS markets in 2012-2015. LCC PAX share is expected to grow in the region of 1% and 2% p.a. (see Table 6 below). Growth Scenario: In this scenario we assume that economic conditions will help FSCs to stand up to LCC competition and limit LCC PAX share growth to 1% p.a. Low Growth Scenario: We expect that intensified consumer price sensitivity will favor LCCs and will help them to increase their PAX share by 2% p.a. (For a summary of assumptions regarding LCC progression in both scenarios see Table 6 below)
Table 6 Estimations of LCC market share on European SH market
Scenario Growth Low growth 5.3 Demand
2011P 38% 38%
LCC market share on European SH market 2012F 2013F 2014F 2015F CAGR '12-'15 39% 40% 41% 42% 1.0% 41% 43% 45% 46% 2.0%
The demand predictions for our scenarios (see Table 7 below) are based on the IATA forecast25 from 2010, which predicted growth of ~4.5% p.a. in 2012-2015. We adjusted this forecast based on the assumed correlation between demand for air travel and GDP growth. Therefore, both scenarios calculate with downward-adjusted trends26 - especially in 2012. Additionally, we also assume that the real air traffic demand is strongly dependent on business confidence (see the Figure 13 below), which may play an even more important role than the GDP development.
24
25
26
Market Share of Low Fares Airlines in Europe, ELFAA and York Aviation Report, see http://www.elfaa.com/documents/LFAs_Market_Share_YorkAviation.pdf Based on IATA Airline Industry Forecast 2010-2014, see http://www.iata.org/ps/publications/pages/airline-industryforecast.aspx The demand adjustment is driven by adjustments to GDP growth as described in section 5.1
36
Close relationship is observed between overall business confidence and air travel demand1
Business confidence (confidence points)
120
RPK growth
Business confidence
15%
100
10%
80
5%
60
0%
RPK growth
40 -5%
20
-10%
0 2007 2008 2009 2010 2011
-15%
1. Corrected for the effect of the ash cloud on air travel demand Source: European Commission, AEA
Figure 13 Relationship between business confidence and air travel demand in Europe
The CIS-Europe demand was also taken from the IATA 2010 report27 and similarly has for both scenarios been adjusted to reflect the assumed development of European GDP growth.
Table 7 Expected demand evolution
Scenario IATA Original Growth - FSC - LCC Low Growth - FSC - LCC
2011P 4.0% 5.0% 3.1% 8.0% 5.0% 3.1% 8.0%
Expected demand for intra-European traffic 2012F 2013F 2014F 2015F Avg. '12-'15 4.6% 4.4% 4.3% 4.3% 4.3% 2.0% 3.5% 4.0% 4.5% 3.5% 0.4% 1.9% 2.4% 2.8% 1.5% 4.7% 6.1% 6.5% 7.0% 6.1% 1.0% 1.5% 2.6% 3.6% 2.2% -2.9% -2.6% 0.0% 0.8% -1.2% 7.7% 7.8% 6.3% 7.2% 7.2%
Growth Scenario: We downgraded the original IATA forecast for the period of 2012-2014. Based on our experience, the air traffic demand is strongly correlated with GDP growth as passenger numbers tend to on average decrease by -1% with every -0.5% decrease in GDP growth (ceteris paribus). Current IMF forecasts for 2012, which served as bases for the scenarios, see GDP growth at 1.5% as opposed to 2% forecasted in autumn 2010 (the time of the IATA study). This corresponds to downward correction of demand 2012 by ~-1p.p.
27
IATA Airline Industry Forecast 2010-2014, see http://www.iata.org/ps/publications/pages/airline-industryforecast.aspx
37
Other indicators suggesting a slowdown in the airline market include business confidence and airfreight volumes. IATA predictions were lowered by an additional -1 p.p. to account for the latest dip in business confidence. Furthermore, freight volume decrease is also supporting the expected demand decline. In the 2009 crisis freight showed to be a very reliable predictor of passenger demand, furthermore similar yet not such severe signs are already visible. A 10% drop in airfreight volume can be seen since May 2011. Because of the expected slow recovery of business confidence after the falloff in 2011-2012, IATA forecast for 2013-2015 has also been adjusted downwards. Despite the correction however, the final assumed trend demand, in this period, converges towards the originally forecasted values. According to our expectations, this growth will be driven mainly by LCCs growing by 6.1% p.a., while FSC traffic should be growing by 1.5% p.a. only. Low Growth Scenario: In the Low Growth scenario, the expected demand drop is caused by larger difference between the assumed GDP and the original outlook for 2012-2015. On the other hand, this downturn may be partially offset by LCC activity. LCCs with their lower prices are expected to have a stimulating effect on demand as we expect them to gain greater market share once markets slip to recession (see the section 5.1. on LCC progression). Also, slower demand growth in years after 2012 is additionally reasoned by weakening dynamics of business confidence and airfreight recovery. As far as FSCs and LCCs are concerned, we assume that FSCs will limit their operations on unprofitable SH routes resulting in decrease of -1.2% p.a. LCCs on the other hand will be getting larger market share at a higher rate (see the section 5.1. on LCC progression), which leads us to expect their capacity growth would be of 7.2% p.a. 5.4 Supply
Assumptions regarding the development of supply on European short haul market are based on ACAS28 information on existing fleets and planned aircraft deliveries. According to delivery schedule, the narrow body fleet capacity in Europe is currently assumed to grow by 3% p.a. This is caused both by expansion of narrow body fleet in service and by increase of the average aircraft size. Current data show that the total growth of narrow body aircraft shall be driven mainly by LCCs growing on average by 4% p.a. on average (see Figure 14). Increase in average aircraft capacity further amplifies the effect of fleet expansion. According to ACAS, the average number of seats per narrow body A/C grew by 10% since 2000 among both FSCs and LCCs.
28
ACAS database providing civil fleet data, see http://www.flightglobal.com/products/acas/
38
LCC growing capacity by 4%, as opposed to 1% in FSCs

Key LCC competitors expected to grow capacity at 10% CAGR... ...while major FSCs seeing only moderate growth
Aircraft
1 500
+4% 1,368 1,414 1,461 1,496
CAGR
Aircraft
2 000
+1% 1,760 1,761 1,826 1,849 1,850 1,805
CAGR
1,309 1,231
587 1 000 608 600
572
564
558
Other LCC
-2%
1 500
500
58 41 81 28 71 129 57 107 92 205 195 188

258 295 308
70 93 151 220
94 94 162 235
110 90 173 253
Wizz Air Norwegian Air Berlin easyJet
+31% +10% +13% +6%

500 1 000
1,167
1,127
1,169
1,198
1,208
1,183 Other FSC
0%
110 149 255
79 88 113 161 272
92 114 163 288
92 114 162 283
92 113 158 279
92 112 154 264
Iberia Air France Lufthansa
+3% +1% +1%
British Airways 0%
308
312
312
Ryanair
+4%
0
2010
2011
2012
2013
2014
2015
2010
2011
2012
2013
2014
2015
Note: retirement age assumed to be 25 years; LCC = Low Cost Carrier; FSC = Full Service Carrier (only Narrow Body fleet) Source: ACAS database, company annual reports and websites, BCG analysis
Figure 14 Narrow body fleet growth to be driven by LCCs current status (ACAS database)
In both scenarios we expect LCC supply to match demand in each consecutive year. This is based on the assumptions that LCCs strategy is strongly driven by seat load factor (with price as the balancing factor) and that LCC business model allows for more flexible capacity management when necessary. The expected development of overall supply on the SH market as well as its split into FSC and LCC capacity is summarized in the Table 8 below.
Table 8 Expected supply development
Scenario Growth - FSCs - LCCs Low growth - FSCs - LCCs
2011P 6.5% 5.0% 9.0% 6.5% 5.0% 9.0%
Yearly SH ASK development 2012F 2013F 2014F 2015F Avg. '12-'15 3.0% 3.5% 3.5% 4.0% 3.5% 1.9% 1.8% 1.4% 1.8% 1.7% 4.7% 6.1% 6.5% 7.0% 6.1% 2.5% 2.8% 2.5% 3.0% 2.7% -1.0% -1.0% -0.5% -0.6% -0.8% 7.7% 7.8% 6.3% 7.2% 7.2%
Growth Scenario: In the Growth scenario we assume that carriers will keep to expected growth rates. The improvement will be driven mainly by LCCs trying to match their increasing demand. Low Growth Scenario: In this scenario we expect that in reaction to slower demand growth the capacity will build up at a slower rate starting with a slowdown of total supply upturn to 2.5% in 2012. The downswing will be caused by FSCs that will start to limit their SH supply in reaction to a lower demand for their services during recession. Customers switching to LCC travel would drive this lower demand. 39
This drop will be mainly down to flight schedule adjustments, as we expect especially FSCs to be rigid in adaptation of their capacity in the short timeframe. In the further years of 2013-2015 we expect carriers to be more flexible and to be able to negotiate aircraft delivery postponements or sell some of their aircraft to manage their capacity supply. 5.5 Airline Costs
We expect fuel to remain the main cost item in the airline business and to be watched closely in the coming years. In our calculations we assume that fuel has a 30% share of total costs of an average LCC and 20% share of total costs of an average FSC operating on SH. The outlook used in our scenario is based on the most recent available estimates of investment banks (see the Figure 15 below). The expected median development of the oil price in next 4 years is to remain relatively flat at 109 115 USD/bbl (Brent crude spot)29 we accept this price development in both of our scenarios.
Median forecast of Brent crude within the 109-115 $/bbl range

Brent crude spot price 24/10/2011
135
Brent price ($/bbl) 140
MAX
130 127 125
120 115 111 109 115 115 MEDIAN
100 95 95 95
MIN
86
80
60
2011 2012 2013 2014 2015
Figure 15 Estimated oil price development (Brent, USD/bbl)
Other costs: We expect that the unfavorable situation on the SH market will force FSCs to cut their operational costs, achieving CASK ex-fuel decline of -1% p.a. in the Growth scenario and a -2% decrease in the Low Growth scenario. As to LCCs, our assumption is that they will keep their CASK ex-fuel at constant level.
29
Based on median value consensus stemming from 15 investment bank reports available as of 24th October 2011
40
5.6
Yields
We expect that the LCC driven structural change of European short- and mid-haul market will continue also over the next 5 years. Therefore we expect the SH yields to decline on average by -2.9% p.a. in the Growth scenario and by -3.7% p.a. in the Low Growth scenario between 2012 and 2015 see Table 9.
Table 9 Expected real SH yield development
Yearly SH real yield development 2011P 2012F 2013F 2014F -5.0% -3.7% -2.5% -2.8% -5.0% -5.0% -4.6% -2.6%
2015F -3.0% -2.1%
Avg. '12-'15 -2.9% -3.7%
As per key components of yield decline, we see three main factors pushing the real SH yields down: LCC competition, potential gap between capacity and demand and inflation. Values used in the two development scenarios combine the effects of the three below factors. However, as the factors are not fully correlated, the scenarios do not take their extreme values to form the boundaries of yield development. Effect of LCCs: LCCs leaner cost structure (see Figure 16) allows them to operate with lower yields and price aggressively. This creates a pressure on yields of the entire SH market (examples from 2010 include easyJet's ~5 c/RPK compared to Lufthansa or IAG's ~10 c/RPK after adjustment for different stage lengths).
CASK 2010 ex-fuel vs. average stage length 2009
14 CASK '10 ex-fuel (c/ASK) 12 10 Icelandair 8 Croatia SAS CSA AF-KLM Finnair Aer Lingus Airberlin Easyjet Ryanair Cyprus Turkish BA Iberia
Aegean
4 Vueling Norwegian 2 0 500 1,000
Network LCC 1500 2,000 2500 Average stage length 09 (km)
Source: Airlines annual reports and annual results presentations, IATA WATS report 2009
Figure 16 CASK and average stage length of European carriers
We assume that there are two LCCs components responsible for the impact on European SH: a) utilization of aggressive pricing by LCCs through which they force the FSC competition to cut prices, and b) a change in passenger mix towards LCC travel causing a decrease in average market yield.
41
As per the first component, lower LCC prices make the FSCs to cut their yields too. We can see that FSC yields are correlated with LCC presence on the market (see Figure 17 below). We assume that increased presence of LCCs on currently less penetrated markets (e.g. France) will push overall yields down by ~12% p.a.
Higher LCC market share results in lower FSCs yields
FSC1 Yield/RPK (indexed)

2.5 France Russia Belgium 2.0 Switzerland Netherlands Denmark Finland 1.5 Italy Spain 1.0 0 10 20 30 40 50 Austria Sweden Label Germany Label UK
Norway Ireland Poland
LCC Penetration (% share of scheduled seats)
1. Using BSP 2010 sales Note: Stage length adjusted to 1.000 KM Source: BSP, Innovata, BCG analysis
Figure 17 LCC penetration putting pressure on FSC yields
Growing LCC PAX share naturally shifts the mix of passengers towards the lower-yielding segments. Assuming that average LCC yield is 4.5 c/RPK and general European FSC yield is 9.5 c/RPK, we expect the effect of higher LCC PAX share to range between -0.7% (Growth scenario) and -1.3% (Low Growth scenario) see the Figure 18 below.
42
Increasing LCC PAX share expected to drive yields down by -0.7% to -1.3% p.a. in the next 5 years
Growth scenario
Low growth scenario
PAX share Avg. SH yield 100
Avg. SH yield (EUR cents/RPK) -0.7% p.a. 8
PAX share -1.3% p.a. Avg. SH yield
Avg. SH yield (EUR cents/RPK) 8
100
62% 50
61%
60%
59%
58%
4
50 2
62%
60%
57%
56%
54%
2 38% 41% 43% 45% 46%
38% 0 2011
39%
40%
41%
42% 0 0
0 2011 2012 2013 2014 2015
2012
2013
2014
2015 FSC PAX
LCC PAX
Note: LCC yield assumed to be EUR 4.5 cents/RPK, FSC yield 9.5 cents/RPK Source: BCG analysis
Figure 18 Effect of changing PAX mix
The gap between demand and supply: While in the Growth scenario we assume matched supply and demand, the Low Growth scenario expects supply to outpace demand by 0.6 p.p (see Table 10). We assume that this will push yields downy by ~-0.3% up to ~-0.6% p.a.
Table 10 Gap between supply and demand
Difference between supply and demand (p.p.) 2011P 2012F 2013F 2014F 2015F Avg.'12-'15 2.5 1.0 0.0 -0.5 -0.5 0.0 2.5 1.5 1.3 -0.1 -0.6 0.6
Inflation: We assume that the European carriers will be able to offset maximum only ~50% of inflation rate by increases in their nominal yields. Therefore, with the European inflation projected at an average of 1.9% (see the Table 5 in the Macroeconomic factors section) should force real yields to drop by -0.5% to -1% p.a.
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The European Short and Medium Haul Airline Market

Description Europe EUR/USD Price in USD/t Europe

Short haul real yields

2 Context and Focus of the Study

3 Market Development in 2010 and 2011

Source: IATA Industry Outlook, September 2011 (http://www.iata.org/whatwedo/Documents/economics/IndustryOutlook-September2011.pdf)

Intra-European airline traffic trends, August 2011

Aug-2011 PAX growth (%)

Source: CAPA Centre for Aviation and company reports

Figure 1 Intra-Europe airline traffic trends

CIS Market Demand

Source: RDC Aviation 2011

Figure 2 Capacity trends in intra-European air travel

Only expanding LCCs on par with 2009 totals after 8 months

ASK's (billion) 350 2009 300 2010 2011 YTD

Figure 3 Short-haul ASK year-on-year growth comparison of LCCs16 and FSCs

Supply Development in the Full Service Segment

Source: CAPA Centre for Aviation (http://www.centreforaviation.com/analysis/lufthansa-earnings-fall-27-asoutlook-deteriorates-further-61765, 1st November 2011)

Significant cost gap remains between FSCs and LCCs

2009/10 CASK ex-fuel on European network3

4 3 2 1 0 0 1 000 1 200 1 400 1 600 Average stage length (km)

Figure 4 Cost variances between FSCs and LCCs

Number of seats and utilization

Sold seats hours/day

5 1.5 = 7.5 hours D Productivity +60% 8 1.5 = 12 hours

84 sold seats +19% +25% +140%

126 sold seats

1. Typical flag carrier 2. Low-cost carrier Source: BCG analysis

Figure 5 Sources of LCC advantage

Profiles and Intentions of Key Players

Airport and Navigation Costs

Figure 6 Short haul vs. long haul yield and ASK

4 Development Scenarios for 2012-2015

Scenario construction approach focuses on key drivers

Key determinants of airline performance

Figure 7 Approach used for definition of the scenarios

Table 2 Parameters of The Growth scenario

2011P 2012F 2013F 2014F 2015F

Demand correction LCCs Supply Real Yield Costs

Growth scenario: LCCs growing stronger than FSCs

FSC SH demand and supply

LCC demand and supply

FSC SH yield -3% Real SH yield -3%

LCC yield -1%

Source: BCG analysis

Figure 8 Growth Scenario: Demand, supply and yield development

Growth scenario: FSCs CASK cuts lag behind RASK decline

Nominal FSC unit cost & revenue

Nominal LCC unit costs & revenue

CASK +2% 105 -0% 105

RASK (PAX reve)

Figure 9 Growth Scenario: Unit costs and revenues

Scenario 2: Low Growth

Demand correction LCCs Supply Real Yield Costs

Low Growth scenario: LCC growth in SH accelerated by crisis

FSC SH demand and supply

LCC demand and supply

FSC SH yield -4% Real SH yield -3%

LCC yield -1%

Source: BCG analysis

Figure 10 Low Growth Scenario: Demand, supply and yield development

Low Growth scenario: FSCs with sharper RASK decline

Nominal FSC unit cost & revenue