For shareholders with a long term perspective, airlines have historically been a high risk, low return investment. Consider the facts. Airlines have significantly underperformed relative to their local stock markets over the long run. Airline rates of return have been highly volatile. On average, airlines have not even earned returns that are sufficient to cover their cost of capital.
It is little wonder then that investors have relatively low expectations about the performance of the airline industry. Not surprisingly, a primary and increasingly urgent goal for senior executives is to find ways to make airline performance more attractive to shareholders. To do so they need to get sharper about finding strategies to create greater shareholder returns.
An important first step is to think about your business the same way investors do - to "take the investor perspective". In pursuit of this goal, some companies have already developed a Shareholder Value Management (SVM) approach to managing their businesses. At the highest level, SVM involves focusing the entire organisation, very explicitly on value creation from the investor viewpoint.
That requires doing a number of things differently within an organisation. Not least, it means developing new, cash based measures of performance that more closely correlate with value creation. Management can then use these as a tool for evaluating strategic plans, making capital allocation decisions, communicating with the investment community and rewarding management for creating real economic value for shareholders.
SVM has become an increasingly popular management tool with many companies in the 1990s as they attempt to find a more effective measure of their cash return on investments, manage their balance sheets, and add discipline to the capital allocation process. Companies as diverse as Procter & Gamble, Monsanto, and Mattel have all made significant movements towards an SVM approach. A handful of leading airlines are now beginning to follow suit. As they do, they will be rewarded with tighter management of their asset base, greater discipline regarding allocation of resources across routes and business units, and a deeper awareness of the true level of value creation inherent in their historical performance and their future plans.
The investor perspectiveShareholders make a cash investment in airlines and expect a reasonable cash return. That comes in two forms: either through regular dividends while they hold a stock; or else from the value they realise when they sell the stock (hopefully for a higher price than they originally paid). The ultimate measure of a company's level of value creation is best defined as the Total Shareholder Return (TSR). This is simply a measure of share price appreciation (or depreciation) plus the total dividends.
For investors, TSR is a relatively simple, objective measure against which to evaluate the performance of an investment and compare it to alternative investment opportunities. For fund managers, it may also determine both personal compensation and the amount of capital that the fund is able to attract over the long term.
Airlines can use TSR to compare their level of value creation to their peer group or to the market overall. Historically, the airline industry on average has not produced very strong TSRs for long term shareholders. In fact, despite some improvement in recent years, the total returns to shareholders have been well below average market performance (see graph). This sort of performance should not be surprising, given that the airline industry has historically earned a return on investment that is nearly three points below the cost of capital. In essence, these companies are destroying shareholder value over the long term. Because of this historical performance, most investors and analysts do not believe that airlines can sustain rates of return that are above their cost of capital. Even when times are good, investors basically believe that airline returns will quickly fade when the economy takes a downturn. In large part, it is this history that explains the relatively low share price multiples in the industry. Some industry observers believe that airlines are now finding ways to "break free" of investor expectations about future performance. Certainly the search for ways to change investor attitudes and create greater shareholder value is now absolutely forefront in the minds of senior industry executives. In order for airline executives to understand truly whether or not they are creating value for shareholders it is important for them to have a suite of useful performance measures.
Performance measuresUnfortunately, traditional measures have not been all that helpful in evaluating airline performance from the shareholder standpoint. Traditional measures alone, like operating margin or earnings per share (EPS) do not accurately reflect the level of value an airline has created for its shareholders. Even EPS growth can be a poor predictor of share price appreciation for airlines.
Simply put, there are two reasons why this should be the case. First, earnings measures are subject to a broad range of accounting distortions that often have very little to do with the level of cash flow being generated by a company's asset base. Second, earnings do not take into account the level of gross investment made to achieve the returns. In other words, earnings do not accurately measure the cash invested in a business (asset base) versus the cash generated by the business (cash flow). Because cash flow is such a key driver of share prices, this divergence results in a poor link between EPS and TSR. In addition, EPS measures do not indicate the proximity of an airline's return on investment to the cost of capital, an important determinant in the level of value that is actually being created for shareholders. Without better cash-based measures, it is tough to know the true level of value that an airline is creating.
It is also difficult to evaluate what value is likely to be created under different strategic planning scenarios or to make the optimal allocation of capital resources. It is certainly difficult to measure and reward behaviour that is actually having an impact on shareholder value.
Cash-based measuresOne of the first steps in taking an SVM perspective is to develop a new, complementary set of measures that are more tightly linked with value creation. That means migrating to cash based measures of performance and incorporating a view of the assets employed to earn the returns. While no measure can perfectly correlate with shareholder returns, such measures have a much higher correlation than do traditional accounting based measures. One way to view the relationship between measures and shareholder returns is to look at how well different measures track with share price appreciation, the primary component of shareholder return in the airline industry.
Using an industry standard price/earnings (P/E) multiple to project share price movements results in relatively poor tracking with actual share price.
Capitalising the cash flows for an airline, on the other hand, actually tracks very closely with share price. In short, cash-based measures are a better tool for airlines to use in anticipating the shareholder value impact of strategic plans and capital allocation decisions.
A broad range of cash-based measures can be used to aid tracking of value creation. Ultimately these can then be "drilled down" to the level of operational value drivers that line managers can control and track.
Actively managing for shareholder value is not just about having better measures. Adopting an SVM approach can also become an important organising framework for managing an airline. With the right measures in place, airline executives can get a lot more rigorous about a broad range of critical management activities. There are key ways in which SVM can lead to better decisions and outcomes.
Greater asset disciplineNot surprisingly, the airline industry is one of the most asset intensive businesses in the world. Despite this fact, airlines seem to pay surprisingly little attention to the real economic cost of assets employed to earn returns. Airlines may look at operational measures like block flying hours for a fleet or a route, but they rarely look at the full picture, that is, the real gross investment that was made to earn the returns on a route or business unit.
Airlines typically spend a lot of time worrying about measures such as operating margin or yield, but very little time managing asset productivity, an equally important, if not more important, driver of return on investment (ROI). Given the asset intensive nature of the business, careful management of the assets has the potential to unlock significant free cash flow in the short run and improve ROI in the long run.
In most industries, asset utilisation (measured as units of output per dollar invested) may vary by 5-10% across factories. Differences are watched closely and are measured in single percentage points. The airline's equivalent of the factory - its aircraft - can have widely differing levels of asset utilisation. An aircraft on a short-haul schedule may generate half the number of seat kilometres as the same model on a long-haul schedule, yielding 50% or greater differences in asset utilisation.
Measuring performance on a simple margin basis, which does not capture the differences in asset utilisation, may yield wildly inaccurate views of performance across routes. Very few airlines have a clear view of the ROI being earned by individual routes, by fleet type, by region, or even by business unit. New measures, including asset productivity and a cash based ROI are required to allocate assets appropriately to their highest return uses.
Non-aircraft assets are also a large component of total investment for most airlines. Yet once approved and on the books, they rarely receive significant oversight. For example, spare parts alone can account for over 5% of an airline's total assets. Maintenance departments generally prefer to have the buffer of a significant spares inventory and since parts are a balance sheet item, they do not impact on anyone's cost budget. Yet holding inventory does have a real cost - a capital cost. Without the appropriate measures, it is unlikely that optimal inventory investments will be made.
To instill discipline into the organisation, accountability for assets must be pushed down into the organisation. This requires apportioning assets to areas of the organisation that control them. For example, engineering and maintenance should know and be charged for the capital cost of its spares inventory. Ultimately, they should also be charged with a capital cost on the days an aircraft is out of service.
Scheduling and market development should similarly have a deeper understanding of the assets employed on routes, including the capital cost of scheduled downtime. Only when asset discipline has been pushed to the managers whose decisions affect the level of assets can capital usage be optimised.
Optimising the networkOne of the major challenges for an airline is to optimise performance across a range of interdependent value drivers. Management decisions affecting yield, load factors, aircraft utilisation, cost and growth are all critical. Yet maximising performance on any one dimension can sub-optimise the overall performance of the airline. The trick for airlines, as with other "network" businesses, is to optimise the tradeoffs. A value management framework allows impact of these tradeoffs to be measured on the level of shareholder value being created.
Some airlines are beginning to use ROI as a way to measure both the network and individual routes. For example, there may be instances where routes are not being flown simply because they are a drag on the average margin. In reality, these routes may help the overall ROI by improving the level of asset utilisation - more seat capacity is generated with the same investment base.
On the other hand, adding flights at 02.00 may improve asset utilisation measures, but if the aircraft are relatively empty, it does not necessarily lead to better overall performance.
Comprehensive measures that include the impact on revenue, costs, and assets are needed to make the optimal decision for the network in total. Looking at margins or yield alone will not necessarily lead to a decision that optimises the return on an aircraft investment.
Another area for possible sub-optimisation is in engineering and maintenance. Most airlines intuitively know there is a tradeoff between minimising cost for maintenance checks and minimising the number of days an aircraft is out of service. These decisions are rarely made, however, with rigorous analysis of the tradeoff between cost and asset utilisation.
For example, managers of maintenance bays are generally measured on minimising cost per check. Using overtime may reduce the days out of service but will increase the total labour cost per check. Since the manager is not rewarded for the asset utilisation benefit of reducing days out of service, they will likely work to minimise only the labour cost. A measure of performance that includes the impact on the airline's assets is needed to optimise total performance.
Strategic decision makingPerhaps the most important benefit of an SVM orientation is the ability to evaluate critical strategic decisions. By having measures that better correlate with value creation, management can make a wide range of strategic decisions more effectively:
* Assessing the shareholder value impact of alternative business strategies
* Projecting the likely share price impact of proposed budgets
* Allocating capital, including decisions regarding the timing and nature of aircraft replacement
* Assessing business unit performance and actively managing the portfolio
* Assessing the value of potential mergers, acquisitions, divestitures, and alliances
* Determining the value impact of route profitability
* Understanding and quantifying the underlying value drivers of various parts of the business
As an example, consider the important strategic choice that senior airline executives face over alternative levels of growth for the business. How much growth is enough and should the airline ever grow at the expense of profitability? By incorporating a view of the impact of growth on shareholder value, a value management approach makes explicit the tradeoffs between asset growth and profitability.
Investors reward both growth and profitability, so improvement on one dimension may actually more than offset a conscious, strategic decline on the other dimension. The lack of tools to make these tradeoffs has led some airlines to overlook potentially value-adding growth opportunities.
Better management reportsAn airline can also evolve its management and board reports to incorporate the new cash-based measures. By frequently reporting and discussing these new measures, the key drivers of shareholder value creation will become better understood by management and board members. Changes over time and variances to plan can be tracked. Impact on likely share price appreciation and equity free cash flow can be forecasted into the future, and any "value gaps" can be identified.
Having measures that better correlate with value creation also allows senior management to set targets that are aligned with shareholder interests and objectively compare performance with other airlines. Setting the "level of ambition" for the organisation is one of the more important activities performed by the senior executive group. Taking the shareholder perspective will help management set appropriately ambitious goals with a much deeper understanding of the impact on real value creation. Ultimately, incentive compensation can and should be explicitly linked with meeting value creation targets.
Finally, SVM creates a common language for management to frame internal debates and to communicate in a language that is more compelling with the investment community. By using a more rigorous analytic framework, management can better explain the shareholder value impact of their decisions to each other, to employees, and ultimately to investors and analysts.
A number of leading airlines are already making progress on these issues, but many have a long way to go. The airlines that get it right will be rewarded with superior shareholder returns.
Source: Airline Business
