How premium leisure travel is rewriting airline economics

0:00Previously, if business cabins were full of business travelers, the demands are actually different from if they're full of premium leisure travelers. And so you have seen airlines refocusing on service, on the food on board, on the wines on board, which are more loved and paid for by the leisure travelers than they are by the business travelers. That's McKinsey partner Steve Saxon. Whether for business or leisure, premium travel is the thing that's contributing to airlines' profitability. But the airline industry as a whole isn't making the kind of profit you might expect. Steve joins me to get into the design, demand, and economics of airline travel.

0:39This is the McKinsey Podcast, where we help you make sense out of the world's toughest business challenges. I'm your host for today, Lucia Raheli.

0:53Steve Sachs and welcome to the podcast. Thank you, Lucia, for inviting me to be here. I would like to start with a really tough question that is the topic of much debate among my children. It's going to draw from your two plus decades of consulting work with our travel practice at McKinsey. Steve, when you fly, are you a window or an aisle man? I'm definitely a window man. You're a window man? You've got to look out and see the world below you. But these days, in the premium classes, window and aisle are the same things. Everything is about aisle access at every seat. Steve, you and colleagues have published an annual review of airline economics every year for something like two decades.

1:47Any trends that you see emerging overall in the industry? The airline industry at the moment is relatively healthy. Many airlines are reporting good profits. However, as a whole, the airline sector is still not quite returning its cost of capital. So even in its most successful years, the industry as a whole is not quite earning the returns which its shareholders and investors would expect. We are recording this in high summer when vacation travel is probably at its peak. Lots of folks flying, but fewer, I would imagine, who actually grok the economics of how airlines make money when we buy a plane ticket.

2:26Give us your best quick and dirty on what most travelers misunderstand here. So the key thing is how thin the margins are of airlines. So yes, you're paying hundreds of dollars for your ticket or maybe thousands of dollars if you're in the premium classes, but all of that money gets spent and it gets spent on the fuel, the aircraft, the maintenance of the aircraft, the crew. And so the actual margins of airlines is very thin. Like the average profit per passenger is barely more than a cup of coffee. But airlines are becoming more profitable. Yes, they've become more profitable in recent years.

3:02Why then is the industry struggling to earn its cost of capital consistently? Some airlines have become consistently more profitable. And you look at the large U.S. carriers and some of the leading European carriers, and they're earning healthy profit margins, which hasn't been true historically. However, if you look at a global average, it's still as an industry not returning its cost of capital. And that's dragged down by losses in other areas. most recently, many of the Asian carriers have not been retaining their cost of capital, for example. Airlines is a uniquely challenging industry. The ticket prices are highly transparent.

3:42You can go on to online travel agencies and you can see and people are choosing different airlines with only a few dollars between them. And at the same time, the power of suppliers in the industry is high, whether that's there's only really two aircraft manufacturers, the power of labor is strong, Many airlines are highly unionized. And so as soon as airlines start to generate profits, the suppliers try to take that away from them. It's also an industry with relatively low barriers to entry. You can start a new airline with only a few million dollars and quite high barriers to exit as well. Many governments will support national carriers in times of challenge.

4:21So it's competitive, strong bargaining power of suppliers, customers switch only a few dollars. and that leads to low returns. How does seasonality affect airline economics and what do airlines do to plan for those kinds of dynamics and trends? The summer is when airlines make the vast majority of their profits. Many airlines are actually unprofitable through the winter. And with the growing growth of leisure travel, this is even more emphasized. Business travel is reasonably consistent throughout the year and provides a good base load. But with leisure travel growing faster, we actually see the airline industry overall becoming more seasonal.

5:01And therefore, even more airlines make their profits in the summer. Have the changing geopolitical dynamics affected travel at all? Demand? People still want to take vacations. Where they're taking vacations has somewhat shifted. We also see kind of where do passengers want to transit. So a growing area has been people not taking a direct flight to their destination, but stopping over somewhere. And this is especially true for premium travel as well. Now, it's probably an understatement to say that many industries have undergone disruptions in recent years. What about the airline business? Has it fundamentally changed over, say, the past decade, or are the economics largely the same as they ever were?

5:48So the industry has always been subject to shocks. And airlines, I think, are unique in how many different types of shock hit them, whether it's pandemics, whether it's terrorism, whether it's volcanoes, whether it's weather effects. And all of these have hit the airline sector. But there has been some changes over time. And one of those changes is the increasing importance of premium travel. And you and your colleagues spend a lot of time studying airline profitability. And as you just mentioned, a theme that keeps emerging is this growing importance of premium cabins. Why are they becoming so central to airline economics?

6:32Well, for some airlines now, the premium cabins are making up more than half of the total revenue of the aircraft. And that didn't used to be true. Obviously, the premium cabins are a smaller proportion of the number of seats. But those cabins have been expanding. The ticket prices have been increasing on those cabins more. And for several carriers now, the premium cabins are more important than the economy class cabin to them. And so who's flying? I mean, business class is called business class for a reason, right? People have historically used business class who are traveling for work. Is that changing?

7:08What's going on there? That is changing, and it's been changing consistently over 20 years. business travel is relatively flat. Premium business travel is not really growing. But the premium cabins are growing and it's people paying for themselves. It's premium leisure travel. Customers deciding that they want to spend a bit more money to make their vacations enjoyable and spending their own money to fly business class, first class, or increasingly some kind of premium economy class as well, which many airlines have introduced because of this trend. And what do you think is driving that? It's interesting because we know from the state of the consumer research that folks are growing increasingly cost conscious in this uncertain macroeconomic environment.

7:50How does the rise in leisure travelers among premium flyers square with that trend? I think there's two things. One is, while large segments of the population, yes, are cutting back and are price sensitive, there are some segments of the population who've actually been doing quite well. And we see them increasingly willing to spend on experiences. There has been a long-term trend of people wanting to spend more money on experiences than physical goods. We saw that post-COVID. We thought it was some kind of revenge travel. But that's actually continued afterwards as well. And today, while some segments of the population are cost-conscious, there is an affluent segment who are increasingly willing to spend, and they're spending on themselves on better experiences.

8:38And when travelers pay for premium, what is it they're after? Is it the better seat or is it that lower friction journey end to end, curb to destination? Well, it's everything. It's from the ability to have premium check-in, not stand in a long line, to get through security quicker. They usually get to the airport well in advance. If you're paying for your own ticket, you want to enjoy the lounge, have a glass of wine before you get on board, have some food. They're paying for a nicer experience. As we said earlier, nobody's sitting next to you. direct access to the aisle, a seat which in many cases these days will go completely flat, an arrival experience which can be quicker through immigration, and better treatment on board with higher service.

9:24And customers are willing to pay for all of these things. What kind of product innovation is happening in these premium cabins? What are you seeing that's attractive to leisure travelers that would make them want to splurge? Given the growth is being driven by leisure travel, we see a lot of innovation. At the very front of the plane, for example, many are now introducing private cabins for first class. Seats which can convert into double beds on board. In the business cabin, aisle access is now common. Innovations in catering, so it's not just a fixed menu, but you can dine on demand. Some airlines have put a chef on board the aircraft.

10:07Really? We've seen better lounges than ever before with spas in them or treatment areas in them. We've seen innovations like private terminals or a private car to take you to the aircraft. When people are spending their own money, they're willing to spend on these kind of experiences. And how do airlines decide how to allocate capital toward those innovations? There's a lot of experimentation. People can come up with no end of ideas. Of course, they all cost money. So airlines will introduce them, will try them, and you'll see them double down on some of the things which work and quietly withdraw some of the things which don't.

10:50The massages on board didn't work, and so the airlines removed those. But I see a lot of investment now going into premium catering, which the leisure customer is willing to pay for. Presumably business travelers and leisure travelers might have different preferences within the same cabin. How does that affect the way airlines think about service? It's actually a big challenge because in the same cabin, you've got people who are looking to get some work done and get some rest versus others looking to have a great experience and enjoy the luxury. And they might have brought their children as well.

11:31There's more children than ever in business and premium classes. And so, for example, what should the cabin crew do if somebody's sleeping at breakfast time? Should you wake them up because they want the premium luxury experience of the breakfast, or should you let them sleep to get the rest? This is one of the challenges of service. They need to understand the customer and what they're expecting. I'm just thinking about traveling with my own kids when they were babies. They were fairly high maintenance on flights. What does the crew do if in first or business there's a fussy baby? How to handle that?

12:06They need to do the best that they can, right? Unfortunately, babies do interrupt business class and there's more babies than ever within the business class cabin. I was on a flight. It was from Melbourne back to Shanghai. My wife and I were both incredibly sick on board the plane with food poisoning. And it was the cabin crew who looked after our kids. Oh, my goodness. That's incredible. Cool. Also, I'm so sorry to hear it. I mean, that sounds very unpleasant to be trapped on an airline during an illness. Yeah, I don't often write afterwards to thank the crew, but that was one of the times I did.

12:42So let's turn to the implications for airlines. What does the rise in premium leisure travel actually translate into for airlines? Has it changed the assumptions airlines have historically made about their customers? So it's led to innovations in the product, first of all. Previously, if business cabins were full of business travelers, the demands are actually different from if they're full of premium leisure travelers. And so you have seen airlines refocusing on service, on the food on board, on the wines on board, which are more loved and paid for by the leisure travelers than they are by the business travelers.

13:21One airline, for example, used to have a business service, which they turned the lights out and you flew overnight to give the maximum amount of rest. That's great for the business customer, but actually many of the leisure customers want to enjoy the flight. And so we have seen airlines investing more into the premium products. We've seen investments into new lounges. The leisure customer arrives at the airport earlier. They spend more time in the lounge, and it's an important part of the experience. And they've also had to upgrade internally as well. If more of your customers are premium travelers, you need to make sure that they are being priced correctly and that you're inventory managing those seats correctly.

13:57And if premium demand remains strong, what are the implications for the future structure of airline business models? The first thing is that airlines respond to demand, and that's why we see the increasing size of premium cabins in many aircraft. Some airlines have reintroduced first class. That was seen as a dying product, but now many airlines have bought back first class because there is a segment of people who are willing to pay significantly more for a differentiated experience. We see business cabins taking up more of the plane. So more of the square footage of the aircraft is dedicated to premium seats.

14:35And we see airlines introducing premium economy class as well. So people who maybe can't quite afford business, but are willing to pay a bit more than the standard coach seat, airlines have introduced a premium economy. So is it fair to say then that if one premium seat can earn several times the revenue of an economy seat, is maximizing seat count becoming less important as a metric than maximizing customer mix? So yes, how airlines think about it is how many economy class seats does a business seat take up. And you need to make sure that the revenue for that business class seat is between three and four times the economy seat.

15:17And if it is, you want to be adding more business class seats to the aircraft. And what are the implications of increased numbers of premium seats for economy seats? Is it fair to say that premium travelers help make the economics of the whole flight work and that helps economy travelers or no? Yes, it is. And the more revenue the airline is getting from premium, the less they need to make from the economy cabin. So a healthy premium demand can actually help reduce the fares in economy class. And that's especially true on routes which are very premium heavy. Where the premium cabin is always full and the airline is flying mostly because of the premium demand, there can be some very cheap economy class fares.

16:06So when a relatively small cluster of premium seats can generate a disproportionate share of profits, how do airlines decide how much space to allocate to those products? Well, the space on board the aircraft is the limiting factor. A premium seat can take the space of, let's say, three or four economy class seats. So they're pretty much weighing up how much revenue they can make from an economy seat versus a business seat and which is higher. However, remember that an aircraft doesn't just fly one route. Airlines are ordering aircraft and they need the same aircraft to fly lots of routes on the network.

16:48And so they're looking at an average as well. And so you'll find that for some routes, there aren't quite enough premium seats, but for other routes, there are too many premium seats. And how to address that then? They address it through pricing. And that's why you'll see that sometimes you can get great value prices in business class and in premium classes. Actually, I tried to upgrade to business on a flight a couple of weeks ago. And business was sold out, but I upgraded to premium economy. and it was super. I mean, it was fantastic. There must have been room in premium economy because it didn't cost me very much to upgrade.

17:27Well, if you look at the profit per square foot of the aircraft, premium economy is actually usually the highest. A premium economy seat takes up about the space of maybe 1.5 times a standard economy seat, but the fare they're charging is often at least double. Yeah, it's interesting because years ago, the trend was toward really densifying those cabins. Seems that you're describing a reversal of that. Well, it still is in economy class because there is a segment of traveler who is flying purely based off the lowest price. And that's why we've seen airlines introduce even things like basic economy class.

18:04So it's a stripped back version of economy, which doesn't include a seat selection or doesn't include a bag or in some cases does not include a meal. And so airlines are differentiating the products. For people who are choosing only on price, I just want to get there for the cheapest way possible. There's economy class and a basic economy class. For those willing to spend a bit more, you've got premium economy. For those willing to spend severely flying luxury, you have business and first class. So they're further differentiating the product to meet different ranges of customer needs. And many airline revenue management systems were built around very predictable customer segments and booking behavior.

18:43If today's premium customer might as easily be a vacation traveler as a corporate road warrior, what are the implications for how airlines should forecast demand? This is a particular challenge for airlines. Typically, when business class was full of business customers, they would book relatively late, and they're reasonably price insensitive. In many cases, they were spending the company's money, not their own, and they were less price sensitive. However, the leisure customers are more price sensitive. They're typically spending their own money. And so what we see is an increasing sensitivity to price.

19:25The challenge for airlines is how to keep the high revenue from those business customers while also still attracting the leisure customers. And they do that through various ways. Things like tickets are cheaper if you book earlier. They might be cheaper if two people travel together than one person travels alone. They might charge less for a connecting flight than they do for a direct flight. Airlines have got various fences, they call them, about how to try and charge more to the business customer while keeping fares competitive. for the premium leisure customer. Question on AI, obviously top of mind for many leaders.

20:02Is AI affecting airline decision-making in any meaningful way? Anything that AI enables that would have been difficult or impossible just a few years ago? First of all, AI isn't going to change that people want to travel. And the growth of travel and premium travel is mostly driven by leisure, and that continues. However, the way people book their flights is changing. Instead of going to the airline website and choosing some drop-down list boxes, maybe you go to an agent. People are already going to the LLMs to explore destinations. At the moment, the LLMs can't book for you. However, it's only a matter of time until they're able to start.

20:42And the airlines are worried about, well, maybe we lose the direct relationship with the customer and people go through agents and LLMs instead. And then the second area is internally. Airlines can do a lot to improve the internal efficiency, whether it's great chatbots to improve the customer service, or improved agents bringing in more data sources to improve the revenue management, or advanced models to better predict the flight routes or the aircraft turnaround. So there's lots of analytics being used to improve airline efficiency as well. And on the first point, do you see airlines acting in order to increase visibility on LLMs?

21:27How are airlines responding to the fact that folks are no longer coming to their own channel or working through a traditional online travel agent, for example? So they're absolutely working with the LLMs. First of all, ideally they would like the LLMs to pass the customer through to them. So if somebody says, okay, I want to book a flight, they would say, great, a good way to do it is to go to airline.com or even I, the agent can help you book on airline.com. And so they're working with the models and with the LLMs in order to enable that. Some airlines are also making their prices transparent as well.

22:04So making them easily discoverable. So if someone goes on an LLM and searches for a particular flight or schedule, they can come back and give you the pricing and give you the availability through the model. Steve, what did you find most surprising about the research that you recently published on premium cabins and airlines? I think the biggest insight was how airlines need to think differently internally, given that the majority of the growth is coming from leisure customers, not business customers. That has implications on how they develop their product. It has implications on how they price that product.

22:44It has implications on how they distribute that product as well. And airlines are going through an internal transformation to focus more on these premium leisure customers. Interesting. Steve, before we close, what's your favorite packing or travel hack? You can travel on any length of vacation with a carry-on suitcase. this is a McKinsey consultant special. I have heard that so many times. You know what, Steve? Really quickly, we asked a handful of other consultants what their top travel tip was. And our North America chair, Eric Kutcher, had a super handy one. Here's Eric. I don't travel with shoe trees because I can always put my socks and undergarments in there.

23:30and it plays a role of kind of both reducing the amount of space, but equally keeping my shoes in reasonable order. Order. It's an aspiration for me when I'm packing. Not always executed. Nice one, Eric. Steve Saxon, thanks for joining us today. Thank you, Lucia, for having me on the podcast. Thanks so much for listening to the McKinsey Podcast. I'm Lucia Raheli. And I'm Roberta Fasaro. Find us on McKinsey.com. We'll have a transcript of this episode up shortly. And if you have any questions based on this episode, please email them to us at themackenziepodcast at mackenzie.com. If you enjoyed the show, we'd love for you to leave a rating and a review.

24:12We'll see you next time.