With most airlines failing to deliver satisfactory shareholder returns over the full business cycle, it is essential to look beyond the core business for profitable growth. But seeking out and exploiting the best opportunities is not easy. Airlines need to combine their unique capabilities or assets with an expansive view of their marketplace. Only then will they maximise the value of their franchise.
This approach has helped a range of companies in other industries - from Gillette to Disney and Thermo Electron - to build successful businesses in new areas and thereby significantly grow revenues, profits and shareholder returns. Curiously however, with one or two notable exceptions, airlines have consistently failed to grow outside their core business, despite a broad range of potential opportunities. This article examines the importance of non-core growth, the reasons why many airlines fail to reach their full potential and the lessons they can learn from the great growth companies in other sectors.
The financial markets reward capital efficient, profitable top-line growth more highly than any other aspect of financial performance. However, for many airlines, growth opportunities in the core passenger and cargo businesses appear increasingly constrained. This is particularly true for airlines in some markets in Europe and North America, where a combination of infrastructure constraints and limited growth in the most profitable market segments is placing long term limits on top and bottom line growth.
Moreover, in some cases, the markets are already expecting more growth than the airlines themselves think possible. Generally this is because the markets believe that there are significant assets (including brands and capabilities) and/or business opportunities which the airlines could and should be exploiting. Increasingly, if airlines want to deliver outstanding levels of shareholder returns, they have no option but to exploit every avenue in which they are uniquely positioned to create value.
Many potential opportunities exist for non-core growth. Broadly, they fall into three categories:
First, separable businesses related to the core passenger/cargo business. These include catering, engineering, maintenance, aircraft financing and leasing, ground handling services and tax free shopping. Airlines' increasing drive to focus only on those areas where they are really distinctive is creating opportunities for others to provide these services. Some opportunities have perhaps already come and gone - airline catering, for example, where a few big players now dominate the worldwide market. However, some of the other opportunities remain unexploited, waiting to be sought out by those that can add value.
Second, businesses that exploit the customer franchise. Through a combination of their brands, their frequent flyer programmes and their extensive customer contact, airlines have the capability to build almost unique relationships with their customers. These relationships give rise to a number of growth opportunities, including car rental, package tours, hotel and resort branding/management, and retail, entertainment and financial services. Some airlines are already heavily involved in many of these areas. Few, however, have so far managed to capture the full value available from their customer relationships.
Third, new businesses that leverage an airline's existing skills and capabilities. This may represent one of the richest areas of future opportunity, but to date there are few examples of airlines branching out in this way. One is Virgin, which has attempted to capitalise on the combination of Virgin Atlantic's customer service, its broader transportation-based skills and the Virgin brand to move into operating railway services.
A wealth of opportunity is not, of course, an argument for uncontrolled diversification. The best growth companies 'stick to their knitting' - but each defines its knitting in terms of its unique assets and capabilities, and actively seeks out and exploits any opportunity where these factors can give it a real competitive advantage.
While many airlines accept both the need to exploit new growth areas, and the fact that there are potentially many such opportunities, very few have succeeded in meeting the challenge. In some cases this is because they have failed to take sufficiently bold action. In others it is because the actions taken were poorly conceived. Only in a few cases have airlines succeeded in pursuing profitable, non-core growth. There are a number of reasons for this lack of success.
Some airlines appear to lack an expansive mindset. Great growth companies share a number of characteristics, but perhaps the most notable is that they take an expansive view of their marketplace. This allowed Gillette, for example, not only to leverage its brand to expand its product range from razor blades, through men's grooming, to a full line of personal care products, but also to see the unique value it could add in acquiring Duracell Batteries. By combining the Duracell product with Gillette's distribution strengths it created US$4 billion in shareholder value. Similarly, an expansive mindset has enabled Disney to grow from making animated films, through running theme parks, to operating holiday resorts (chart 1). To date, however, few airlines have demonstrated an ability to think creatively, expansively and strategically along these lines.
Equally, some airlines do not appear to have a deep understanding of their distinctive assets and capabilities. This is a second key distinguishing feature of great growth companies. Airlines need to be able to articulate, in detail, their whole capability platform and understand the distinctiveness and value of each element (chart 2).
Further, airlines have organisational structures which tend to constrain their ability to identify and pursue new growth ideas.
Airlines' large, single business structure hampers new growth ideas. Unlike many large corporations, airlines do not contain a broad range of separate businesses, each with a CEO, a bottom line and an overall strategic focus. Instead, most are dominated by just one business - the core airline - and tend to organise along functional lines, often with a regional matrix overlay. This type of structure helps maximise the opportunities available within the core business, such as network design and scheduling, but hampers the growth of new businesses. New ideas or concepts tend to be reported to one of the functional heads. As a result they can get less focus than the core business or, worse still, may be run to provide maximum short term benefit to the core business, even if this hampers their long term growth.
Airlines have very rigid pay scales and conditions of employment. The single business, highly labour-intensive nature of an airline often makes it difficult to structure reward and incentive programmes appropriately for new growth businesses. This can be exacerbated by union contracts designed for the core airline business and inappropriate for new business ventures.
Nor do airlines develop the entrepreneurs needed to create and build new businesses. Airlines' organisational structure naturally places most profit responsibility at the top. In addition, it tends to create very specialised and highly skilled functional or operational experts. Few employees get the broad, general business experience appropriate to creating or running a new high-growth business. For these reasons airlines do not have a strong track record of developing outstanding entrepreneurs.
In addition to an organisational structure that hinders the rapid exploitation of new growth ideas, airlines also tend to have fairly risk-averse cultures. They are high-profile businesses which get a lot of publicity. Rightly, therefore, they are very protective of their brands and their image, as public trust is fundamental to their overall proposition. The fear of failure is often a big issue, stopping airlines from pursuing high-profile, but risky, growth ideas.
Finally, many airlines are affected by hangovers from the past. After all, some of their most well-known, non-core growth strategies have failed. Allegis and the SAS expansion into hotels and other travel services are perhaps the most well documented examples. In the Allegis case, United believed it could grow significantly by capturing its customers' spend on related travel activities such as car rental and hotels. Its intention was to leverage both its customer relationships and the power of its CRS system, Covia. To do so, it believed it needed to be vertically integrated, and therefore in 1985 it spent over $1.6 billion acquiring Hertz and Hilton. However, it was never clear that ownership of the physical assets in these other businesses was a prerequisite to capturing the value. Nor did United have the support of the market: in 1986 it had substantial losses, high costs and a reputation for poor communications with the financial community. For all these reasons Allegis traded well below the group's breakup value. In June 1987 - following action by both United's pilots and a well-known US buyout firm - the board decided to sell off the non-core assets and abandon the strategy before it was fully implemented.
SAS also acquired hotels and other assets in order to capture more of its customers' spend and subsequently sold most of them and retrenched to its traditional core business of flying.
In contrast, there are very few examples of airlines which have successfully implemented a broadly-based growth programme. Swissair, which has developed into the SAirGroup, is perhaps the most striking example. Since the early 1990s Swissair has strongly expanded into major adjacent businesses, in particular, airline catering and duty free sales. To help maintain focus, the SAirGroup today has an organisational structure that gives equal weight to each of its four divisions: the passenger airline businesses; the logistics (cargo) businesses; the services businesses; and the relations businesses, including catering and duty free sales. The non passenger airline businesses now account for over 50 per cent of revenues, compared with 24 per cent in 1990. And in 1997 these businesses accounted for about 60 per cent of the SAirGroup's combined earnings before interest and tax (Ebit). As a result Swissair/SAirGroup has produced greater returns for its shareholders in the last six years than almost any other traded airline stock.
American Airlines is an equally good example. First, it created and grew Sabre, ultimately spinning part of it off in a similar way to other excellent growth companies. Now American is rapidly growing a number of new ventures in the management services area such as call centres and airport management. However, SAirGroup and American are rare examples among the large airlines of the world. Most have rigidly pursued the idea that sticking to one's focus means sticking to the core business of flying.
So what needs to be done to identify and capitalise on growth opportunities? The prerequisite is a strong and respected core business. Few weak companies have grown themselves out of their troubles and fewer still have done so in new areas of business. The opportunity to pursue growth in new areas depends on both a strong track record in the core business and real credibility in the financial markets.
Once these have been attained, what do the leaders of great growth companies do? Broadly, they focus their efforts across three dimensions: creating a stretching commitment to grow; driving the development of new growth engines; and cultivating the environment of entrepreneurship in which growth thrives (chart 3). In each of these areas there are a number of practical actions which airlines can take to start a successful growth process.
A commitment to growth means setting aggressive growth targets which are shared among the senior management team and expand their mindset about what is achievable.
A growth investment fund must also be established. The capital budgeting process itself can often be an unintentional block to new growth ideas: trying to compare a one-off, new idea with other core-related investments can be very difficult. Instead, a fund should be set up that is independent from the investment needed for the core business. New ideas should then be compared and evaluated relative to each other to identify the best. Clearly, criteria are needed to justify new investment. However, having committed to growth, the intention should be to invest - if there are not enough good ideas then that should be viewed as a failure against the growth aspirations.
Lastly, the airline should invest heavily in communications. A compelling growth vision needs to be created that will inspire the organisation and, importantly, the financial community. Pursuing growth is not easy and there will be setbacks along the way. Airlines must invest in proactively communicating with, and managing, all the key stakeholders to ensure that each understands the underlying logic of the vision and the challenges to be addressed. Failure to do this well will almost certainly damage the long term success of the venture.
There are also three key steps in the building of growth engines. First, develop a clear understanding of your own distinctive sources of competitive advantage. These include: competencies or capabilities; privileged assets - such as brands, network, infrastructure, technologies and patents; and special relationships with governments, distribution networks and customers, for example. It is important to be rigorous about where these sources of advantage can truly distinguish an airline from its competitors. It is not enough to have a valuable capability that is not distinctive.
Second, develop processes to ensure a continuous stream of well thought-through new business concepts. However strong the organisational momentum for growth, a poorly conceived business idea will almost certainly fail. Rigorous and creative thinking is critical, and the best growth companies invest heavily to get this thinking right. They also invest in a process of continuous idea generation, to ensure that the pipeline is always full.
Third, recognise where opportunities have greater potential as separate businesses rather than supporting the core. Many growth ideas can spring from the original goal of supporting the core business. Expanding catering and maintenance to serve other carriers are examples. The trick is to recognise when the potential value of serving the wider market is greater than the advantage of serving the core business on an exclusive basis.
Cultivating an entrepreneurial environment is often a critical challenge for airlines. The first step is to create a growth business unit which is separate from the core business, and have its leader report direct to the CEO or chief operating officer. This will create the transparency and accountability necessary to address the growth challenge, and avoid the risk of these new activities becoming submerged by the core business.
The growth unit must also be staffed carefully. Success will depend on special behaviours, attitudes and skills. In many cases airlines will need to attract key individuals from outside, both in order to enhance skills and gain new perspectives.
Third, the development of new incentive and evaluation systems is essential. An aggressive growth programme will often require individuals to take greater personal risks with their careers. Additionally, it is important to create an environment which reflects the intensity and spirit that characterises entrepreneurial, high-growth companies. Therefore, the remuneration and performance assessment processes must attract true entrepreneurs, appropriate risk taking should be encouraged, success rewarded and mediocrity weeded out.
Last, the need for managed experimentation must be accepted and some failures along the way are inevitable. Experimentation and trial may be the only way to get certain businesses going - both to test viability and build the knowledge on which success may depend. This should be encouraged while the new growth businesses must have sufficient time to prove themselves. Finally, since not all the growth ideas will succeed, a culture will be needed in which poorly performing ideas can be weeded out without necessarily deeming these endeavours failures.
Of course, not all these steps will apply equally to every airline. However most will have to manage the tension between the new growth businesses and the core business; not an easy task. This will require strong leadership and judgement to manage the various forces pulling the company in different directions. Much will ultimately depend on the personal leadership and strength of vision of the CEO. However, as the SAirGroup and American have shown, successfully pursuing new growth ideas and effectively managing the tension they create, can deliver a strong performance and tangible rewards for shareholders and stakeholders alike.
Source: Airline Business
