Flying Cheap

On April 1, Europe fully deregulates air travel. Passengers could get a bonanza

Karl-Heinz Jork is not a popular guy. As in-house travel manager for German electronics giant Siemens, he has decreed that everyone but top management must fly economy class in Europe. With hundreds of employees in the air on any given day, he also drives hard bargains with the airlines. Jork's pfennig-pinching has already sliced his annual budget of $1.2 billion by 10%, even though the number of trips taken is up. Siemens managers call him "Travel Lopez," after the purchasing czar who slashed costs at General Motors Corp. and Volkswagen. "I'm not sending people on kamikaze airlines," says Jork. "Doing without hot breakfast is not a matter of quality and safety."

His job may soon get easier. On Apr. 1, Europe will take the final step in its 10-year journey to total air deregulation. After that, European airlines will be able to fly between any two cities in the European Union--even on domestic flights inside another country. Since 1993, they've been able to operate between any two EU cities across a national border. But this last phase will throw open to full competition domestic routes long dominated by national flag carriers that have used their monopolies to keep prices high.

Europe's transition to open skies has been far gentler than in the U.S., where air deregulation in 1978 led to the demise of such hallowed institutions as the original Pan American Airways Inc. Yet a shakeout looms in Europe, too, as low-cost upstarts challenge national airlines on their home turf. To cushion the blow and save jobs, governments continue to prop up such flag carriers as Air France, Alitalia, and Iberia at taxpayers' expense. But things will get nasty soon. "It's going to be much more of a dogfight than most people envisioned five years ago," says Frederick W. Reid, the 46-year-old American who will take the controls at Lufthansa on Apr. 1.

Shaking things up are entrants offering simpler fare structures, electronic ticketing, no meals, and low, low prices. They are exploiting a growing demand for low-frills flying by cost-conscious companies and recession-battered consumers. Brussels-based Virgin Express, Germany's Eurowings, and Britain's easyJet are targeting cheaper, secondary airports, such as London's City Airport and Berlin's Tempelhof.

The innovations are surely creating more traffic. One specialist, Fariba Alamdara of Britain's Cranfield University, reckons that without liberalization, only 59 million passengers would have flown in 1994 instead of 73 million. Air fares have gotten so much more affordable that they are tempting people away from Europe's rail network. Neither the Paris-Lyon high-speed train, which decimated air traffic when it opened in September, 1981, nor the London-Brussels Eurostar Express can always beat the cost of a plane ticket today. Although some people will always need the flexibility of frequent, full-service flights, many don't mind doing without the little extras.

Discount flights on heavily traveled routes, such as Munich-Barcelona or Paris-Toulouse, are causing headaches for Air France and Lufthansa. And with monopolies still controlling two-thirds of all the routes in Europe, new targets abound. "It's like the birth of democracy in a dictatorial state," says Franco Mancassola, chairman of Britain's nine-month-old Debonair Airways.

Of course, it will be European-style democracy. Industry watchers don't expect the Big Bang that air deregulation brought in the U.S.--largely because a European government is unlikely to let its flag carrier go out of business. While the EU says it's cracking down on budget-squeezing subsidies, they won't disappear anytime soon.

In addition, at Europe's major slot-controlled airports, including London's Heathrow, Berlin's Tegel, and Paris' Orly, governments call the shots. They can limit the number of slots to keep competition out. And in contrast to the U.S., airlines can't buy and sell slots without government approval. So new entrants must use secondary airports or concentrate on less-traveled routes.

SLASHED. Nevertheless, some upstarts are already driving down fares on formerly monopolized routes. Ryanair has snatched 40% of Dublin-London traffic from Aer Lingus. The result: a price drop to $94 round trip, down some 44% from Aer Lingus' fares of 10 years ago. When Norway's Braathens SAFE started flying the Stockholm-Oslo route last fall, it offered a $263 round trip with no restrictions. Scandinavia Airlines System (SAS), which was charging $500, bounced back with express check-in, a Travel Pass allowing 10 trips without prebooking, and a matching fare. And when Italy's Air One introduced its Rome-Milan flights a year ago, it forced Alitalia to cut off-peak prices by 42%.

Stung, national carriers are scrambling to figure out which routes it makes sense to defend. Since they often lose money on short hauls, many of those will be subcontracted. For instance, Belgium's Sabena World Airlines has given its flights between Brussels and London, Barcelona, and Rome to Virgin Express. High-cost Sabena sheds unprofitable routes, and Virgin gains Sabena's precious airport slots. Passengers, meanwhile, get prices 50% lower than Sabena's former fares.

Another tack the giants are taking is to franchise shorter routes to startup carriers that operate 30% to 40% more cheaply yet still carry the national brand name. British Airways PLC has eight franchisees, mostly under the umbrella name BA Express, flying throughout Britain and into Scandinavia, South Africa, and the Mideast. And Chairman Robert Ayling aims to double his franchise business. Lufthansa so far has three German franchisees flying domestic flights as Team Lufthansa, where operating costs are as much as $40 per hour lower.

A riskier way to crack new markets is through subsidiaries. BA has tried to carve out slices of German and French routes via subsidiaries Deutsche BA and Paris-based TAT European airlines, with mixed success. In France, it has also bought troubled Air Liberte, largely for access to its slots at Orly. It's an expensive way to gain ground. James C. Halstead, an airline analyst at Credit Lyonnais in London, estimates that BA lost $109 million on TAT and DBA in the 12 months ended in March, 1996.

FACELIFT. But Carl Michel, who heads business development for BA and will take over Deutsche BA on Apr. 1, is forging ahead with the strategy. He is giving the German subsidiary a facelift by repainting planes and tripling his marketing budget, to $15 million, this year. Deutsche BA aims to be a solid No.2 in Germany by pricing about 15% under Lufthansa. In January, it added two new routes within Germany--Munich-Cologne and Munich-Hamburg--and Michel has his eye on two more. "The good times are coming to an end for Lufthansa," he predicts.

The flag carriers don't have much time to remake themselves. Healthy traffic is buoying even the most troubled players right now. European airlines together recorded $1 billion in operating profit in 1995, after five years of losses totaling $7.5 billion. Even Iberia, which is being kept aloft by government subsidies, last year posted a net profit of $24.9 million, its first since 1989. But by 2000, notes Keith McMullan, director of airline consultant Avmark International in London, they'll have to be ready for the next downturn. "European carriers are only just realizing that national cost structures aren't compatible with deregulated markets," he says.

The next phase of their survival strategy is likely to be a rush into new worldwide alliances. Industry experts see three to five global groupings emerging over the next decade. In Europe, the most likely powerhouses will be BA, KLM Royal Dutch Airlines, and Lufthansa, each a strong contender with a powerful U.S. partner. Lufthansa, United, SAS, and Thai, which already have passenger-sharing agreements, may reinforce their ties. And as European governments continue to privatize their flag carriers, these companies will be ripe takeover targets.

Will U.S. airlines move in on Old World turf? Industry insiders say the big American carriers have little interest in picking up regional routes within Europe. But those with partnerships that feed transatlantic traffic into their domestic flights expect deregulation to boost business as the strong European airlines get stronger.

For example, United Airlines Inc. has code-sharing agreements with Lufthansa and British Midland Airways Ltd., Britain's second-largest noncharter carrier and its

No.2 holder of slots at Heathrow. Cyril Murphy, United's vice-president for international affairs, says the airline will capitalize on British Midland's new freedom to expand its feeder operations. And he expects Lufthansa to be one of the winners under deregulation, adding: "Every transatlantic passenger Lufthansa carries means more revenue for United."

Among the Europeans, the coming months will bring a scramble of deals. On Apr. 1, Air France and Alitalia will begin a code-sharing pact, with cooperation in ground handling and frequent-flier programs. KLM, already in an acrimonious but profitable partnership with Northwest Airlines Inc., is looking to add a southern European partner. KLM has approached Iberia, but according to a U.S.-based industry source, Northwest thinks Alitalia would be a smarter move. "The dance cards are filling up rapidly," he says.

Lufthansa's Reid, who aims to slash his costs by a further 15% over the next three years, is not interested in propping up weak carriers with high costs. "We worked too hard to get this far," he says. Instead, Reid is talking with British Midland, whose costs are 20% to 25% lower than Lufthansa's. Sir Michael Bishop, chairman of British Midland, notes that Lufthansa is no longer interested in certain routes between Britain and Germany. "We might have those," says Bishop, adding that no equity stake is planned.

As the flag carriers jockey for position in Europe's newly open skies, a few already look like long-term winners. British Airways, the world's most profitable airline, has been cutting costs for years. Although it faces many new rivals, it has been toughened by experience in a competitive market since Britain began airline deregulation back in the 1980s. SAS has a similar edge because Sweden deregulated its domestic market in 1992 and most of KLM's traffic is in the highly competitive intercontinental market. Another advantage for the biggies is the lack of slots at big airports such as Heathrow and Frankfurt.

Indeed, while the newcomers are making progress, it hasn't been easy. According to an EU report, 80 new airlines have taken to the skies in Europe since 1993--and 60 of them have already failed. Take Air Liberte, which opened 23 new cut-rate routes in France in early 1996 but didn't keep a grip on costs. It offered full-service flights--with even more champagne than Air France. When Air France cut its fares, Air Liberte, forced into bankruptcy, wound up in the arms of BA.

FARE WAR VET. Adding to the challenge, the giants are putting tough managers into their top ranks. Swissair has hired Jeffrey Katz, most recently managing director of passenger sales for the western U.S. at American Airlines Inc., as its new president. BA's Robert Ayling, who took the reins in January, 1996, is maintaining an aggressive focus on the bottom line. In promoting Reid to president, Lufthansa has created a new unit that gives him freedom to manage the passenger business separately from the rest of the group. Before joining Lufthansa in 1991, Reid ran European sales for American Airlines and spent the first nine years of U.S. deregulation at the old Pan Am. "I know what it's like to be part of a dying company, and that's not going to happen again," he says.

Still, some national carriers seem fated to disappear. Sabena was already faltering when Swissair took a 49.5% stake in 1994 for $171 million. The Belgian carrier posted a record $254 million loss last year after losing money since 1992, and this month, Swissair gave it three months to prove it can turn a profit by 1998. In April, Swissair will decide whether to write off its investment. Analysts predict it might eventually ground the Belgian airline.

Most vulnerable are the flag carriers that have been sheltered by protected markets and government handouts. These include Alitalia, Iberia, Air Portugal (TAP), and Greece's Olympic Airways. Politicians are still trying to carry these dinosaurs. Since 1991, European governments have spent $5 million per day keeping their planes in the air. In 1994, the EU declared a "one-time, last time" policy for letting governments bail out their airlines. But governments can still sneak around it with temporary subsidies targeted to specific restructuring goals. Just this month, Italy decided to double a "one-time" state gift to Alitalia to $2 billion. Last summer, Air France received a "final" $1 billion tranche of aid, prompting Lufthansa, which no longer gets government money and will be fully privatized this year, to file a complaint with the EU.

DIZZYING DEPTHS. Yet even the most nationalistic governments will have a hard time keeping the flag carriers afloat as the rivalry heats up. And the fare wars could descend to dizzying depths. Kyle B. Davis, director of American Express Co.'s Airfare Management Unit in Paris, says that compared with traditional routes in the U.S., a 500-mile cross-border trip in Europe costs, on average, 43% more.

No wonder passengers love the fresh air of competition. Jan Krieger, a 43-year-old architect in Berlin, flies to Stuttgart once a week on business. He takes Lufthansa only when he can't get a seat on Deutsche BA--and not just because the upstart is slightly cheaper. "Deutsche BA is friendly and more relaxed." Just one more thing to make the big carriers tense.