A collective shudder could be (or should have been) heard among competing airlines and airports when AirAsia X was announced last week. Its proposal to become Malaysias second long haul flag carrier with a new low cost model based at KLIA creates a precedent at a critical time in the regions aviation evolution. The beginning may be modest, but then so was AirAsias first international foray.

And, as AirAsia CEO Tony Fernandes was not shy to point out, anyone who says the long haul low cost model "can't be done" should recall what they said when AirAsia first went international three years ago. Today, low cost airlines account for one in ten of all seats flown in the Asia Pacific region, low by global standards, but uniquely high where international routes are involved.

Coincidentally, the announcement also comes as Qantas is caught in the headlights of equity investors, triggering a likely round of strategic reappraisals - and probably airline merger and acquisition activity - throughout Asia. AirAsia itself is positioned nicely in this equation, as numerous investors circle the region's market.

And the airport hub battle steps up a notch, as Kuala Lumpur International Airport looks set to achieve added focus for long haul activity.

In a widely anticipated announcement, the leadership of AirAsia on 5-Jan-07 presented its plans to launch a long-haul operation, using the iconic Malaysian LCC's brand. AirAsia X, which boasts the slogan "Now everyone can fly extra long" (adding the last two words to its longstanding motto), intends to commence operations from Kuala Lumpur to three destinations, one in Europe and two in China, in Jul-07. Services to other destinations in India, Australia and elsewhere will follow.

The carrier will be operated by Fly Asian Xpress (FAX), the company established by AirAsia founders Tony Fernandes, Kamarudin bin Meranun and Raja Mohd Azmi to operate the Government-subsidised routes between the country's smaller cities that were vacated by flag carrier Malaysia Airlines (MAS). Fernandes says that the long-haul venture will have initial capitalisation of MRN80 million.

LCC Alliance. Not Just Yet?

Although pre-announcement speculation had focused on the formation of an alliance between AirAsia and European carriers Virgin Atlantic and easyJet, AirAsia X will - at least for the near future - operate as an independent, self standing corporate entity. Certainly an alliance of some nature involving partners of this stature could potentially be a powerful competitor.

FAX CEO Raja laid out the plan the carrier, which bills itself as "the world's truly low cost long-haul carrier", will follow, while maintaining that the other LCCs operating long-haul services - a list that includes Qantas affiliate JetStar, Viva Macau and Hong Kong-based Oasis Airlines - are hybrids and not true followers of the low cost business model.

Key Features of AirAsia X's Business Plan:

1. Cost control is emphasised - lower c/ASK than AirAsia
2. Low, transparent fares - high passenger volume
3. Focus on developing ancillary revenues
4. Active brand management and marketing strategy
5. Creation of win-win alliances
6. Point-to-point medium-long-haul services from key Malaysian cities
7. Connections offered, but no hub-and-spoke operating model
8. Single aircraft type and simplicity
9. Over 16 hours/day utilisation
10. Frills (IFE, food and drinks, more comfortable seats) available for purchase
11. Distribution will initially be travel agent reliant
12. Assigned seating

AirAsia CEO Fernandes says the carrier will start operations with three aircraft, will have five in operation by the end of its first year of service, and will reach its full size of 20 units by the end of year four.

The carrier has narrowed its fleet choices down to two models, the A330-300 (with a conversion to the A350-XWB when it becomes available) and the B777-300ER, with a decision to be announced between Jan-07 and early Feb-07. Interestingly, the Airbus product would require a technical refuelling stop en route to Europe (although the yet-to-fly A350 would not).

Passenger Service: Modifying The Product for A New Category of Operations

The AirAsia X service proposition is still also being ironed out, although the carrier has committed to offering a product that is more suited for long-haul operations. It has also stated its intention to offer two classes of service, with the premium cabin featuring an almost-flat bed-seat. For the main cabin, it will offer food and in-flight entertainment on a user-pay basis, pricing food in a way that will encourage passengers to purchase in advance.

The long-haul product will diverge from AirAsia's regional offering in two main areas. It will offer assigned seating and it will probably - according to Fernandes - sell alcohol on board. The latter will be a key contributor to the generation of ancillary revenue, but will be a departure from the current practice of AirAsia Berhad, and even its joint venture operators in Indonesia and (non-Muslim) Thailand. Perhaps a delicate topic, Fernandes still does not believe this will be a political problem. Malaysia's primary full service carrier "MAS serves alcohol," he notes.

Schedule: Services to Europe, But Principally A Medium-haul Operator

AirAsia X has stated its intention to start by operating services on three routes from Kuala Lumpur's low cost terminal (LCT): Hangzhou (near Shanghai) and Tianjin in China, and a city in the UK. As of now, the carrier has been granted rights to fly to Manchester, but it is making little secret of its desire to secure rights for London's premier low cost facility: Stansted Airport.

The yet-to-fly airline is considering cities in Continental Europe, such as Berlin and Prague, as well as Australian airports as likely recipients of service down the line, but Fernandes says that AirAsia X will ultimately be principally a medium-haul carrier. The 30-year AirAsia brand franchise licence to be granted to the airline will contain a restriction that AirAsia X may not "compete with AirAsia's existing destinations within a four hour flight range". The licence delivers AirAsia 0.05% of the long haul revenues for the use of the iconic name (which has gained currency in Europe through the sponsorship of Manchester United).

He believes that the mature airline will operate 75% of its capacity on routes within the region (initially, longer-haul operations will comprise 40% of the network), having designated any city over four flight hours away from Kuala Lumpur as a potential candidate. He cites Malaysia's multicultural composition - which includes large numbers of ethnic Indian and Chinese - as a factor that will support services within the greater Asian region.

AirAsia and AirAsia X: Details Evolving, But Arm's Length Relationship

The business relationship with AirAsia appears to be evolving. A Memorandum of Understanding has been signed, giving AirAsia an option to acquire up to 30% of FAX exercisable within the next five years.

What is clear is that the AirAsia and AirAsia X will operate totally distinct from each other, with separate management teams. Fernandes, who explained that he wanted AirAsia to maintain a pure focus on traditional LCC operations, says he will not be involved in the day-to-day management of the intercontinental arm.

The carriers, which Fernandes says will enjoy a "symbiotic relationship", also intend to generate feed for one another, with single ticketing and a single fare, composed of the fares of the respective legs combined ("prorate is a dirty word for us," the founder laughed, underscoring the airlines' continued commitment to simplicity throughout operations).

AirAsia Relationship Summary: The Key Players

Source: Centre for Asia Pacific Aviation

Malaysian Government: Beginning of A New Era in State Regulation of The Sector?

One of the most striking aspects of the development is the role the Malaysian Government played in facilitating it. For years charged with protectionism in propping up an until-recently unsustainable MAS to the detriment of the nation, the AirAsia X ceremony featured the presence of the Ministers for both Transport and Tourism and a message from Prime Minister, Dato' Seri Abdullah Ahmad Badawi, who wished the venture "every success".

Minister of Transport, Y.B. Dato` Sri Chan Kong Choy, the Centre's Aviation Minister of the Year for 2006, stated that AirAsia X will enjoy the full support of the Malaysian Government. When asked how the Ministry felt about exposing MAS - which for the first time is undertaking a bona fide self-reform campaign - to more competition, he noted that for the first years of operation, the two would not compete head-to-head.

The Minister stated that London airports Heathrow and Gatwick would be off limits to the new airline and that even Stansted was no certain bet. "We want two national carriers, playing complementary roles, with no direct competition," he said.

That said, he allowed that it was possible the two could compete on long-haul routes in the future. In a statement that augurs well for the nation and provides a positive role model for other national transport agencies, the Minister gave a straightforward answer to questions about on why he is exposing struggling MAS to still more competition.

"This venture will provide stimulus to the Malaysian economy and the tourism industry [which is currently undertaking a large-scale media campaign entitled Visit Malaysia Year 2007]. Most importantly, it's good for the country," he stated, later adding that he expects to have meaningful dialogue with his Singaporean counterpart in the first quarter of 2007 on the topic of opening the Kuala Lumpur-Singapore route.

LCC Long-haul - A Winning Strategy?

Unprecedented levels of state support or no, the key question is: will it work? Will AirAsia X be able to fill its aircraft at fares which exceed its costs?

Fernandes has little doubt that it will. Pointing out that Michael O'Leary, whom he calls the "best airline manager in the industry", has tried to get into long-haul operations through Ryanir's seemingly scuttled take-over of Aer Lingus, he says AirAsia X has a model that can make money, even in market segment vastly different from the one where it has made its reputation.

The company says its fares will be on average 50% of what the competitors are charging, and it made a grand spectacle of its lead-in MRN9.99 fare to the still-to-be-named UK destination, and Fernandes believes this will be more than enough incentive to get people on its aircraft, especially when the downline feed is taken into account.

"So many people could fly for the first time when we started AirAsia," he says. "And now so many people will fly to Europe for the first time." He adds that cargo, a portion of the business that is beginning to post accelerated revenue growth at AirAsia, has not even been built into the current business plan, but can be counted upon to add significant incremental revenue. "That will be cream," the AirAsia chief says.

With fares 50% below the competition, it will need to have costs at least proportionately low. Fernandes does not see that as a problem, saying that his team has identified numerous areas where costs can be subtracted from a long-haul operation. Although declining to elaborate on the specific areas, he says AirAsia X will post system unit costs of US cent 1.9/available-seat kilometre. "And that's a conservative figure," he states, adding that Singapore Airlines' unit costs are about USC4-5/ASK.

Challenges A-plenty

Still, few would dissent with the statement that the low cost model brings its most effective comparative advantage on shorter stage-length routes. Longer operations flatter every carrier's cost lines, and this is even more evident with very large aircraft, which will typically post lower unit costs than the A330 or even B777. Longer flights also make it more difficult to post substantially superior aircraft utilisation rates. (With the other new low cost participants in this market still new to the game, it is impossible to draw any lessons from their experience.)

And that does not even account for the inevitable competitive response, which will be intense, especially from the Middle East carriers who are enhancing their own schedules into Kuala Lumpur and with whom it will be directly competing on services to Europe (all the more so if AirAsia X selects the A330-300 and has to make a technical stop in the Gulf region - albeit perhaps with full fifth freedom rights to uplift/discharge in Dubai for example).

These carriers already have low costs and can offer competitive fares that, combined with their full service offerings, will make a compelling offer to anyone flying from Malaysia to Europe.

Fernandes acknowledged that AirAsia X faces stiff challenges, when he addressed the staff and said: "Nothing is easy. There will be days when you want to give up. But you must always be prepared to box another round." But he also noted that the industry predicted failure when he announced he would apply the LCC model in Asia and that no one is laughing now.

Nothing is guaranteed, in this industry above all others, but, given their success in the short-haul arena, Fernandes and his team have certainly earned the benefit of the doubt.

AirAsia X at A Glance:
Launch: Jul-07;
Base: LCC Terminal at Kuala Lumpur International Airport;
Network: UK and China (Tianjin and Hangzhou) initially, with services to Europe, India, Middle East, Australia, South Korea and Japan later (destinations not disclosed);
Fleet: Three aircraft initially, with plans to acquire 20 new aircraft, including either B777-300s or A330-300s by the end of the fourth year of operations;
Traffic: Expects to carry 500,000 passengers in its first year;
Regulatory: FAX has been granted Malaysian Ministry of Transport approval to operate long haul international air services;
Capital: FAX has further invited AirAsia to participate in 20% of the equity of FAX via a capital injection at par value in FAX on the basis that FAX's future prospects will be significantly improved as a long haul carrier and that FAX's existing Turboprop Operations will only be a small part of its total operations.

Is AirAsia overstretching...

To be embarking on a major fleet increase, at the same time as a new investment in an untried low cost-long haul operation may appear to be a risky venture. AirAsia now has 150 A320s on order, together with 50 options, following its recent 100 order increase. To be acquiring a new fleet of A330s or B777s simultaneously obviously requires considerable capital resources, even if the entities are separate but joined at the head.

...or just making itself more attractive?

In the speculation leading up to last Friday's announcement, one story had "Virgin" taking a share in either AirAsia or in the new venture. Virgin Atlantic just happens to be owned 49% by near neighbour Singapore Airlines, so it was always unlikely that the airline would be a partner (or then again, is it, in this fast changing environment? - although a Virgin Atlantic official expressly denied any intention to invest). A more likely candidate would be Virgin Group, which is controlled by Sir Richard Branson's interests.

It was the Virgin Group which was the founder of Virgin Blue and which has made no secret of its interest - so far unsuccessful - in getting involved in other low cost airline ventures, from Macau westwards.

There is a lot going on right now in the Asia Pacific region. For example, Texas Pacific Group (TPG), one of the key potential investors in Qantas (which includes its long haul, low cost Jetstar International, as well as its holding in Singapore-based LCC, Jetstar Asia) is headed by David Bonderman, Chairman of Ryanair. Bonderman, through Indigo Partners, also holds a share in Singapore Airlines' subsidiary, Tiger Airways.

So Virgin Group will understandably be keen to stake its claim in the region's LCC market, especially since it was largely carved out from Virgin Blue last year.

Even before Bonderman arrived on the scene, Qantas CEO Geoff Dixon was courting AirAsia (among others) and there is still a lot going on behind the scenes. TPG, in making its bid for Qantas, made it clear that the airline sector is growing in attractiveness to private equity, as airport investors push those infrastructure prices through the earnings multiple roof.

The Qantas buyer group, styled Airline Partners Australia (APA) also has a board and advisors who have intimate knowledge of the Asian airline market. So further M&A activity in the airline sector in Asia is not just likely; it will be highly surprising if this story ends here.

Virgin Group is not the only one lining up. Another party in the APA Qantas buyer group, Macquarie Bank, is not shy of seeking interests in the aviation sector. easyJet, another airline mentioned in last week's rumours as a potential X partner, has also shown interest in participating in the region's LCC activity and a host of equity groups and large financiers like Deutsche Bank are very much players in the low cost airline sector. To date Ryanair has shown no interest in Asia, but the Bonderman link in Jetstar/Qantas may influence their future strategy.

So, in fact AirAsia is probably not extending itself too far financially. It could simply be making itself so attractive to potential investors in this phase of market development that it will drive up its potential value for any one of these, or other, investors. Certainly the share market doesn't seem too worried; AirAsia shares have climbed by some 10% in the past three weeks.

The Asian market is a fertile breeding ground for investor opportunities, with equal doses of liberalisation and new travellers opening up massive traffic expansion opportunities.

AirAsia has the attractions of a large and expanding market share, the lowest airline costs in the world, a brand name to die for - and unquestionable recent profitability. It is pretty likely that the strategists and number crunchers in more than one bank and investor group are working overtime to see how a deal would be structured. And, if there's one thing that the TPG/Macquarie/Allco bid for Qantas has done, it is to make it clear that airlines in this region are in play for the equity investors. The equity hounds are baying and the whole jungle is listening.

AirAsia X is to be a separate company with its own management - a perfect vehicle for investors. So there is at least one more shoe to drop. Who will be making the investment in the second Malaysian flag carrier? And how long will it be before further "strategic" moves are made on AirAsia itself?

An eventual IPO of AirAsia X is one option, but watch this space...

The Flow-on Impact for Airports and Airlines

The fact that the Malaysian Transport and Tourism Ministers were very much part of Friday's announcement graphically shows the national interest in the "X" move. That in turn means that it has significance not only for Malaysia Airlines and for Kuala Lumpur International Airport - but also very much for neighbouring airlines and airports, from Singapore Changi, to Jetstar International.

So we can expect in 2007 to see a series of repercussive responses, from airports and airlines alike. In short, the "X" move is likely to rock the foundations of the aviation system in the Asia Pacific region. Only gently at first, but don't be fooled. These guys mean business.