Balancing act

Reducing reliance on the core passenger business looks increasingly attractive to mainline carriers struggling in a volatile market. But while it offers rewards, managing a portfolio of different businesses and products poses challenges too

Airlines have often experimented with ways to expand beyond the core mainline business. Some have entered new sectors such as hotels, or turned existing operations in engineering and catering into full profit centres, while others have launched subsidiary airline brands. However, while many have made half-hearted attempts to diversify, few airline groups have looked at their businesses with an eye toward crafting a comprehensive and integrated portfolio management strategy.

Lufthansa is one of the few that has, and demonstrates the benefits that it can bring. The German flag carrier was reorganised in 1994 around a new group structure in which the passenger airline is surrounded by other closely related businesses. Units such as Lufthansa Technik, the LSG Skychefs catering unit or Lufthansa Systems have since emerged as world players, while cargo and charter operations are now in standalone businesses. At the same time, dependence has been reduced on the passenger airline sector with its inherent instability. Airline revenues now account for just half of the group total, down from 70% in the mid-1990s. Earnings volatility has been cut to half of the typical rate in the airline sector and, as a result, Lufthansa's stock price has grown twice as fast as many of its peers. Other portfolio management leaders in the airline sector, such as Singapore Airlines, are having similar success.

Today, with pressures mounting on traditional mainline carriers, the trend towards portfolio strategies is accelerating. The network majors are under heavy assault from aggressive low-cost competitors and many are now developing new businesses designed to recapture their customers. Many mainline carriers too have found their core operations taken hostage by labour unions demanding ever higher wages, while fresh capital has been difficult to attract due to a highly volatile track record on earnings. Some have responded by restructuring their company and seeking to cash in the value that may be locked up in divisions ranging from engineering through to loyalty scheme management.

Air Canada is a case in point. Its recent aggressive restructuring of the business has seen it create valuable standalone subsidiaries (such as Aeroplan or Air Canada Technical Services), while also generating a series of new airline units, such as Tango, Jazz and Zip, with unique brand propositions. Other leading carriers too are following suit.

However, few airlines are fully prepared for the challenges of such a portfolio management strategy. Managing a collection of separate businesses is very different to running the business as an integrated whole. Airlines will face many issues related to the new business model, but at least three will be key to the success or failure of the strategy: consistent financial management; effective brand development/management; and efficient organisational design.

Consistent financial management

The factors which drive performance for an integrated airline operation are familiar enough. On the one hand network, schedule and product help to drive unit revenues, while, on the other, labour and asset productivity drive unit costs. However, once the business is devolved into separate operating entities, the picture becomes more complex.

Beyond some basic measures of volume, airline-related businesses do not necessarily share a consistent set of performance drivers. Consider, for example, the difference between a catering and an engine maintenance operation. The first is driven by issues of labour intensity and logistical complexity, whereas the second is focused on materials management and cycle-times. In short order, a portfolio approach will produce a spectrum of operating units at different stages of maturity and with different degrees of complexity, both within and across the businesses. This creates several difficulties. First, there is a need to compare and contrast performance of business units in both the same and different industries. Second, there is the challenge of understanding the structural market differences and potential of each area. Third, there is a need to integrate and simplify performance data for effective and efficient decision making.

Therefore, an approach must be adopted which very clearly communicates a credible strategic intent, and uses a value framework that consistently measures and manages performance. Such a framework should allow management to evaluate and judge the performance of all the businesses in the group, against the strategic intent, using a common yardstick. This must provide a "line of sight" from vision to operating decisions, and also allow for easy comparison between multiple business models. It should also mesh with shareholder performance expectations over the short and long term. The yardstick that best meets all these requirements is cash generation.

For different business models, cash will be generated in different ways. So, the first step is to understand the cash-generating activities for each business. Key elements of this analysis are:

identifying and breaking down the assumptions that drive cash flow in the business; defining the relationships between key assumptions; mapping the hierarchy of cash flow generators; establishing activity ranges and conducting sensitivity and scenario analysis.

Once this analysis is complete at the business unit level, targets can be set for each business relative to shareholder expectations.

The value drivers for the individual business can then be used to assess overall risk and return probabilities over the short- and long-term. As each business will have a different life cycle, generating different returns and entailing different risks over time, identifying the sources of value allows the management team to allocate resources and adapt business models across the portfolio to maximise overall enterprise value.

The final part of the plan is to implement a performance management process which will set acceptable ranges for each cash flow target and develop tools to track targets and alerts to identify when target ranges have been breached. It should also set timeframes for each individual target and establish review cycles. Last, but not least, the process must identify who will be responsible for each target and develop a process to ensure decision making at critical action points.

Brand development

At the same time that airline group managers consider the financial structure of their portfolios, they must also understand how the customers perceive and interact with each business. Brands are a critical component of this interaction.

Brands are signals to customers, and serve as repositories for perceptions and experiences about a company. Ultimately, brands create an expectation of the value likely to be delivered, and represent an opportunity to establish a bias to buy. Everything that touches a customer affects the equity of the brand.

In the airline sector, brands have distinct imagery. Lufthansa Technik, Singapore Airlines, Ryanair and Sabre all have unique and strong brand equity. Putting such brands in one stable, however, would be tricky. Ill-defined and overlapping brands in a portfolio can erode price premiums, weaken production economies and lead to sub-scale distribution. In today's slower economy, the problems associated with an underperforming brand portfolio are even more acute. While adding brands is easy, it is more difficult to harvest the value in a brand or to divest it. There is also the question of whether or not to incur the risk of a master brand.

A master brand may stunt the growth of highly differentiated brand propositions in the portfolio. Equally, the need to be relevant across a wider market territory may put undue pressure on the master brand itself. These issues were certainly relevant to the problems faced by the first generation of low-cost "airline-within-an-airline" products, such as Continental Lite or Delta Express. Delta seems to have taken the lessons to heart with its recent launch of Song, a new low-cost offering.

At the product level, brand managers looking to drive incremental growth in market share often attempt to broaden their positions with the target audience and new customers by adding branded offerings, like seats or lounges. In a portfolio world, this may create overlap with other brands, confusing customers and weakening the company's overall value proposition.

As brands and products proliferate in the airline sector, managers will need to view the offering across the portfolio to find the right balance among products, individual brands, and category brands.

Managed correctly, portfolios of distinct brands and products can be incredibly effective. As can be seen in the chart below, Marriott has done extremely well with its stable of hotels, including Ritz-Carlton, Marriott, Courtyard, Residence Inn and Fairfield Inn. Each of these brands, despite sitting in a different part of the market, has tended to yield better average rates per room than its nearest competitor (see graph above). Airline executives could do worse than look to the experience of other industries such as hotels and retailing as they attempt to find their way through the uncertainties of playing the portfolio game (see separate panel on page 70 for examples).

Lessons from other sectors clearly demonstrate that effective brand portfolio management requires a selective approach to where investments are made. It also requires that managers explicitly test the implications of brand portfolio moves against key economic measures, including market share, price premiums, scale economies and other financial variables. Only when the link is made between intangibles and hard benefits can companies exploit the full potential of their brands. Establishing the link requires creation of a fact base about the equity and economic contribution inherent in each brand. The brand's economic drivers - pricing, production efficiencies and distribution strategies - must be well understood. Air Canada's early success with Tango can be traced primarily to a focus on these issues. Tango gives the customer notice that if they change behaviour (use the Internet) and expect a modest but consistent product offering where they "pay extra for extras", they will be rewarded with a low price.

Looking ahead, airline managers who want to manage their brand portfolio to drive profitable growth should follow four precepts:

1. Align brand portfolio with business designs

Successful brand portfolio managers embed branding decisions into each aspect of the company's business design, from customer selection to the internal organisational system, using divisional or business unit brands as part of creating and protecting unique business designs within the company. At the same time, they recognise the need to minimise the complexity and cost in managing a portfolio.

2. Consider building the pyramid

Most large companies manage their brand portfolios as a disparate collection of individual brands. By doing so, they blur the boundaries between each brand and diminish their differentiation. Also, very few companies take advantage of the opportunity to offer a brand at each price point in their respective pyramids, limiting themselves in how they can use branding to their advantage. Airlines are in a good position to do so. The more progressive are now not only segmenting the aircraft cabin but also taking that segmentation further to create new differentiated airline operations.

3. Grow winners and harvest losers

Adding brands to a portfolio can be an important part of pushing deeper into existing markets or extending into new categories. But in a slower economy, companies are finding they have to concentrate investments on a smaller group of power brands if they are going to be successful. These are generally leading brands that command a price premium, have an edge in distribution, global scale, or another critical advantage and therefore have the greatest opportunities for profit growth.

4. Play the cards you are dealt

Many companies in search of growth try to extend brands in their portfolios to adjacent or entirely new markets. That can lead to expensive mistakes. In the USA, successful Seattle coffee chain Starbucks learned the lesson when the company attempted to sell branded furniture. Rather than stretching a brand so far that it snaps, the more effective tack can be to build or buy a new brand.

Efficient organisational design

Even the best portfolio of business models, brands and products will not perform well if it is not effectively managed. The airline industry, with its intense focus on assets, customer contact and technology, provides a challenge. The aim is to balance the management depth required in each of these areas with the potential organisational efficiencies available across the portfolio as a whole. Large network carriers add an extra geographical dimension to management complexity which highlights the need for a delicate balance between centralised and local control.

Most airline-related subsidiaries in the portfolio, such as loyalty programmes and heavy maintenance, will have their own unique requirements in terms of organisation and capabilities. The solution is less clear when launching new airline brands within the group. The first round of attempts to launch an airline-within-an-airline were characterised by the offerings from the US majors in the 1990s such as the US Airways MetroJet or Shuttle by United. They tended to fail because they were too closely enmeshed with the parent company.

Learning from those lessons, more recent launches such as Go from British Airways or Air New Zealand's Freedom Air have been more successful. Ultimately, these types of businesses will need the flexibility to make their own market-based decisions for the core business, in areas such as operating philosophy, labour agreements, product offering, branding and marketing.

On the administrative side, most types of subsidiaries will also need dedicated functional heads - finance, human resources, IT, purchasing and so on. These must clearly understand the business design and its unique requirements. Underneath these individuals, however, the case for a large staff of functional experts is less clear. For example, while the nature of the IT application will vary between businesses, the functional expertise will not. As airlines expand their portfolio, they will need to consider the implications for their organisation to avoid potentially expensive duplications of effort.

One option is to provide a pool of resources at the holding company level for common functions such as IT, finance etc. Accounting for the cost of these "shared services" can be designed many ways, including:

Consultative: charge for services as required on an hourly basis or as a day rate, with specific "contracts" for specific service requirements; Minimum commitment: agree base services that everyone must sign up for at a minimum, including level of support and associated charges; Apportioned cost: divide charges based on assessment of quarterly assets and resources used by each business unit; and Corporate centre: keep all charges central as a "group" support cost.

Another option is to build a base level of expertise and capacity for each type of functional support in each business. These entities should, at a minimum, form committees to ensure they are eliminating as much duplication as possible. For example, human resource personnel need to review new pension regulations only once. They should also ensure that they are leveraging their collective scale where important, for example in recruitment or purchasing. As demand dictates, these functions could supplement as required from the corporate level or by outsourcing. Finally, despite reporting to the business unit, the common functions may also want a common physical location to foster intellectual development and career pathing.

In summary, there are challenges that face any company pursuing a portfolio management strategy, but especially for the already complex airline industry. However, the benefits can be attractive for those who understand and manage the financial, branding and organisational issues that portfolios throw up. By following these guidelines, and learning from experience in other industries, today's airline executives will have a better shot at enjoying the capabilities distinct business portfolios can bring to more closely meet customer needs, while delivering strong financial performance to shareholders.

Brand lessons Observations in other industries can provide the airline sector with some useful examples to answer the questions of when and how it makes sense to add a new brand to the portfolio: Can a brand be repositioned, or is it more cost effective to launch a new brand? Tobacco giant Philip Morris recently announced it is changing its corporate name to the Altria Group, placing a big bet that the new brand will overcome the deficiencies of its predecessor. Can the brand propel the offering into new markets with an advantage over competitors? Kodak experimented with licensing its brand to toy makers. McDonald's is betting that its brand will extend to its Golden Arches hotels in Switzerland. Which brands in the portfolio should have a global, regional or local presence? Philip Morris's tobacco business is trying to sort out which brands should stand alongside Marlboro on a global basis. Electrolux, meanwhile, is searching for the best mix of global and regional brands. Should some brands in the portfolio be used as a firewall to protect other brands in the portfolio? The Swatch Group successfully used its Swatch watches to protect the highly profitable Omega and Rado brands from encroachment by competitors. Should brands in the portfolio be used to exploit channel opportunities? John Deere is re-branding its consumer tractors under the Scott's brand for distribution through Home Depot to minimise channel conflict. Once a brand is in the market, can it be removed from the portfolio without losing disproportionate franchise share or profitability? US brewing company Miller removed the Miller High Life beer brand from the premium category and put it in the below-premium category. After an initial bump in volume, Miller has continued to lose market share.

About the author Michael Zea is a vice-president in the Aviation Practice at Mercer Management Consulting, currently based in London. Further contributions were made by John Paul Pape, also a vice- president at Mercer with a focus on value-based financial management, and Andy Pierce, a vice- president at Lippincott Mercer with a focus on brand strategy.

 

REPORT BY MICHAEL ZEA AT MERCER MANAGEMENT CONSULTING IN LONDON

Source: Airline Business