Changing dynamics

Domestic routes, traditionally the undervalued siblings of more lucrative international services, are leading aviation’s fight back from COVID. But how long is this likely to last? OAG’s senior analyst, John Grant, investigates.

The last eighteen months have been the most challenging in the history of commercial aviation, balance sheets have been wrecked, demand shattered, and perfectly good aircraft broken up for scrap.

Jobs have been lost, years of experience and knowledge leaving the industry for ever and talk of another pilot shortage looming very quickly. And yet there is a near record number of new airline start-ups planned this year, experimental routes being tested and a boom in both cargo demand and operators.

The speed with which our industry has moved is staggering; changes in networks, fleets, refinancing, constant schedule changes and creative revenue generation has underpinned many airlines still operating services today.

But one part of the survival story has gained little analysis and press coverage. It might be functional rather than exciting, but domestic markets have been central to both airline survivals and the financial strength of some carriers.

It is no coincidence that many of the airlines that are struggling to recover, global brands such as Singapore Airlines, Cathay Pacific, KLM and the Middle East’s ‘Big Three’, would have loved large domestic markets in the last eighteen months; the fact that they haven’t, explains some of the challenges they now face.

The key question is, of course, is the ‘domestic flip’ a long-term change or a short-term solution before normal services are resumed.

Domestic capacity has always dominated

Intuitively we all know it, domestic capacity has always been larger than international; it’s just hard to get excited about a new service between two cities in the US Midwest or France when you can talk about a London – Perth non-stop.

In the good times before COVID-19, domestic capacity accounted for around 60% of all global capacity with around 280 million seats a month. Today, that capacity share hovers at around 80%, although in absolute numbers is down around 260 million seats a month.

By means of contrast, international capacity currently sits at around 90 million seats a month; less than half of the pre-pandemic levels and with a sluggish recovery curve still expected may linger below the 100 million mark for the remainder of the summer season.

In the majority of regional markets, the balance between legacy and low-cost airline capacity has become well established, and any adjustments in capacity have been marginal.

A notable exception in the last few months has been in the US market where the low-cost share of capacity has increased by just under three percentage points as carriers such as Frontier, Allegiant and Spirit continue to develop their presence and challenge the legacy carriers.

That position may change back to the more normal levels of share once legacy carriers have access to international markets and rebuild connecting traffic, but for the moment it is a growing position for those carriers and one that they claim is profitable.

Big Is beautiful

One of the early insights from the pandemic was that those countries with large domestic markets were likely to be more resilient from a capacity perspective, although in some cases demand proved to be a very different story (see Table 1).

Large geographic distances, poor alternate or time evasive competing travel options and a historic reliance on flying resulted in some of those countries such as China, The United States, India and, perhaps surprisingly, Japan, absorbing the impact of COVID-19 better than many.

In some cases, airlines rapidly adjusted their networks and focused on their domestic markets, especially in the United States and Vietnam.

In others, some ‘directional’ changes were suggested by the authorities, China being a case in point. And some airlines just continued to operate as best as they could through a national lockdown, Chapter 11 filings and some interstate restrictions such as those witnessed in Australia.

By means of comparison, the range of selected countries in Table 2 highlight just how badly some major markets that historically had more than one million seats a month, remain impacted by travel restrictions and spikes in infection rates.

Both Hong Kong and Singapore remain at less than one fifth of their normal levels making it virtually impossible for the locally based carriers to operate profitable services. Having access to historic large domestic markets has clearly helped some airlines but resulted in some very different approaches being taken.

China directs, the US CARES and Australia isolates

It’s a broad comment, but no two countries have handled the pandemic in the same way and no two countries have supported or guided their airline industries in the same way.

First into COVID-19, China restricted and continues to restrict international services, very quickly instructing airlines to turn towards more domestic services and as part of the national economic recovery.Travellers were encouraged back to flying with some very attractive local fares; in some cases, described as ‘cabbage fares’ because of the low cost. Domestic capacity returned to near normal levels within six months of the first capacity cuts and now stands at 75 million seats a month, some 10 million more than January 2020, an impressive if perhaps profitless 19% growth in eighteen months.

Recently load factors have been above 65% on a regular basis and a few airlines have reported operating profits, but that in truth may disguise some previously excessive international and loss-making capacity growth.

Central Government intervention has certainly worked in China during the pandemic and not just from an aviation policy perspective. Increased personal duty free limits for purchased goods has resulted in a 30% increase in domestic capacity to Sanya on Hainan Island, and a feeding frenzy of tourist with an average spend at the tax free airport of nearly $900 per traveller!

The CARES act in the United States received mixed reviews; it was certainly well funded, a clear message of support and, ironically at the end, large parts of the fund went unclaimed. But some requirements around continued operation of scheduled services made no commercial or environmental sense to the airlines or taxpayers, despite the ability to appeal such requirements.

US airlines have been particularly creative in their network designs during the pandemic. Legacy carriers have introduced ‘hub by-pass’ services, low-cost carriers employing a spirit of adventure have broken into new frontiers, and small airports are seeing dramatic growth in air service. Will it last? Probably not, but certainly some will stick.

In Australia, the almost zealot like closure of international services save for a bubble across the Tasman, may have resulted in relatively little COVID-19 impact but is proving a very hard jail to break out of. Complete closures of international capacity in the early stages of the pandemic may have been very sensible, but the subsequent re-opening of international services is proving to be very difficult, especially for an Island or continent so distanced from most other parts of the world.

One interesting part of the domestic market phenomena has been the number of new airport pairs created; there seems to be weekly stories of new routes being launched; particularly in the United States.

However, as the data below shows, across three of the largest domestic country markets, whilst the number of airport pairs operated in China and the United States have increased in the last 18 months, Australia has lost some airport pairs. This difference is based around Australia’s domestic carriers having struggled through Chapter 11 and other reorganisation processes resulting in some major network adjustments.

Domestic tourism has become crucial

Traditionally in any destination marketing organisation, the plum jobs pre-pandemic involved glamorous trips overseas, huge travel fairs and luxury side trips, all of which made the job a dream position. Domestic tourism involving a pop-up stand in some regional city on a wet weekend in a two-star hotel didn’t attract the same enthusiasm… until COVID! In nearly every country with a domestic market, domestic tourism has become central to the recovery of both their airlines and airports.

From travel vouchers to air fare rebates, extended leave, special events, added value vouchers and even tax breaks governments, regional authorities and trade associations have creatively stimulated domestic tourism. ‘Staycations’ have become fashionable and particularly in those large countries there has been enough take up to suggest that as a short-term recovery strategy domestic tourism can help fill aircraft, rebuild traveller confidence and generate some revenues, so all of that has been good.

However, domestic travellers tend to be lower yielding for airlines, airports and every part of the holiday purchasing chain than international visitors, and ultimately, for airlines, airports and hotels; yield per passenger will at some point become an important metric once again. And that is perhaps the key questions around the rapid growth in domestic capacity, is it sustainable and profitable for a long-term future or is it merely a short-term survival strategy?

Revenue at the expense of yield

Domestic yields are typically lower than international for a number of reasons. A smaller proportion of premium traffic is obvious, higher levels of frequent traveller redemption and competition all impact yields as demonstrated in the tables on page 28, which compare yields for the US majors by international and domestic networks.

Taking data from the US DOT, the tables show the average yields for a range of major carriers operating both domestic and international services throughout last year. Unfortunately, we await the latest data release for more insights from the DOT.

Not surprisingly, average fares fell for all carriers during 2020 as COVID-19 impacted demand in both the international and domestic markets, although Spirit Airlines international yields held stronger than many others; perhaps a result of a changing network structure.

Domestic average yields fell by as much as 30% in the case of American Airlines from Q1 to Q4 whilst for the yields for both JetBlue and Spirit remained virtually unchanged.

It would be no shock to anyone to know that domestic operations are not as profitable as international services and for some airlines domestic and short-haul services are a necessary evil that feed the long-haul operations.

Indeed, at least one major European airline philosophically accepts a negative margin on their short-haul network as long as sufficient connecting traffic is generated for the long-haul services. Unfortunately, that piece of philosophy falls down in a pandemic when connecting traffic is virtually zero.

An abundance of caution frustrates recovery

The last year has seen many new words and phrases, COVID-19 never existed two years ago, the use of unprecedented has well, become unprecedented, no one or company was pivoting and an abundance of caution sounded like something only a bank manager would say! Eighteen months on and these phrases are holding the whole airline industry to ransom and frustrating any signs of a recovery.

In recent weeks many countries, particularly in Asia have been positioning themselves for a ‘zero based COVID-19 existence’, an enviable if somewhat impossible position in a global economy where trade has to take place between countries.

That desire for a zero-based position may be based around a low uptake or availability of vaccines as seems the case in Australia and New Zealand or more of a political message, either way it is unsustainable in the medium to short-term.

And while in the short-term domestic tourism can be incentivised to fill the gaps, it is neither as profitable – or more importantly – sustainable. After all, if you have seen one big red rock, a big wall or a mountain in a national park, at some point product wear out occurs and travellers will crave for international destinations.

And demand for international capacity will recover

As sure as we are that there will be further COVID outbreaks, international demand will recover, although the rate of recovery will be variable in different markets and consumer confidence in no further lockdowns will be crucial.

Travellers will want to visit friends and family, bucket list holidays will be ticked off, premium class demand may be stronger and eventually business travel will return. It is only a matter of time. So, what does that mean for domestic travel?

Well, for one thing, there will be more routes, ‘spoke to spoke’ services will continue, some of which will be operated by new airlines, and competition will increase at least in the short-term.

Domestic demand will remain strong as staycations continue to be popular amongst certain market segments and, very importantly, connecting services will be supplied to those recovering international routes.

We must, however, remember that the current strength of the domestic market is relative to the near meltdown of international capacity. Even today, domestic capacity is still some 20% below its normal levels, it’s just a lot better than international capacity.

As the recovery of international capacity accelerates, the balance between domestic and international capacity will revert back to previous levels of around 60% of global capacity. And when that point is reached some people may once again see that market as the little brother of international travel, but will equally recognise that it is a very important little brother.