How Air Canada Is Adding Capacity Without Hurting Pricing Power

A three-part strategy allows Canada's flag carrier to grow without hurting market airfare prices.

Apr 9, 2014 at 11:03AM

Airlines have traditionally suffered from a situation where capacity growth is essential to growing revenues. But growing capacity itself has frequently been damaging to all airlines as more supply lowers prices and compresses margins.

But Air Canada (TSX:AC.B) is taking a series of approaches to this problem. It's allowing the Canadian flag carrier to add capacity and grow revenues without destroying its own pricing power.

The international approach
As its name implies, Air Canada's home market is Canada, which the airline has served for the 77 years since its founding. But with a population smaller than the state of California, growing Air Canada requires holding a major presence domestically while operating an international network.

The Canadian air travel market is dominated by Air Canada and WestJet Airlines (TSX:WJA). Air Canada has long found itself pressured at home by WestJet but the latter has yet to make a major push into the international market.

By adding capacity in markets where it does not presently compete, Air Canada can add capacity without hurting pricing power on routes it currently operates. This has been a big reason behind the airline's addition of more European destinations being rolled out in 2014.

The discount approach
On Canada Day (July 1) of last year, Air Canada rouge flew its first flight. Air Canada rouge was part of Air Canada's plan to cut costs and move into new markets. The subsidiary is being tasked with taking on new European and sun routes that would be unprofitable for mainline Air Canada but make financial sense for Air Canada rouge due to the subsidiary's lower cost structure.

Not only has Air Canada rouge given Air Canada a way to generate a profit on routes previously not served due to excessive costs but rouge is also a core part of Air Canada's fleet modernization strategy. As mainline Air Canada continues to take delivery of newer, more fuel-efficient aircraft, the older aircraft have to go somewhere. Instead of trying to sell them to other airlines, Air Canada is using the older aircraft to grow rouge's fleet. This is expected to grow the fleet to as many as 50 aircraft over the next few years from 13 aircraft today.

With this strategy, mainline Air Canada can become more cost efficient through the latest as well as older aircraft (which are otherwise not cost effective for mainline Air Canada) and find new life with rouge.

The high-density approach
Since the additional cost of more passengers on the same aircraft is small compared to the costs of operating the aircraft itself, airlines are eager to put more passengers on each plane. Air Canada is rolling out its high-density Boeing 777 aircraft in an effort to drive cost per seat down. With more than 100 extra seats per aircraft over the standard configuration, the airline can add capacity while not incurring the costs of operating additional aircraft.

This strategy allows the airline to add capacity in already-served markets since the capacity addition does little to increase total airline costs. With other airlines taking their own measures to cram more seats into a plane, it will be interesting to see what other high-density configurations Air Canada could unveil.

Responsible capacity
Capacity has long been the enemy of airline profits, but at the same time, capacity is a major factor in revenue growth. Air Canada has employed a three-part strategy to growing capacity while not destroying its pricing power within Canada. As the economy moves further from the darkest days of the recession, airline investors should keep a close eye on how all carriers manage capacity.

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Alexander MacLennan owns shares of Air Canada. This article is not an endorsement to buy or sell any security and does not constitute professional investment advice. Always do your own due diligence before buying or selling any security. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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