In many industries, concentration forces have led to a few large mass producers with a global reach, each striving to achieve the lowest unit costs through increased efficiencies and higher production volumes. In the airline industry, global alliances are being created to achieve similar goals. However, the individual airline operators can be broken down into carriers that operate large volume aircraft to gain economies of scale, and global network builders that concentrate on building economies of scope.
Virtuous circle
The volume-based alliances operate large aircraft that provide distinct unit cost advantages over the smaller aircraft of network builders. In theory this cost advantage allows high volume airlines to generate additional traffic through their ability to offer lower fares. These lower air fares open new markets, resulting in extra demand for larger aircraft, which in turn reduces unit costs and allows further fare reductions. This virtuous circle should continue to strengthen the position of volume operators.
Economy of scope operators aim to increase volume by adding destinations and frequencies. In theory this should not be as effective in cutting unit costs as introducing larger aircraft. The big question for today's strategists is whether a global alliance achieves the volume and cost advantages sought, or whether their participants remain mere groupings of individual operators.
British Airways and, to a lesser extent, United Airlines qualify as volume operators. American Airlines, KLM-Northwest, the Delta group and Lufthansa are economy of scope operators, expanding their networks rather than increasing unit volumes. They enter the virtuous circle one step behind volume operators.
The virtuous circle suggests that the alliance with the largest capacity aircraft will have the lowest unit costs and therefore the best long-term competitive position. This explains why volume operators actively support the launch of the A3XX, which is crucial to their continued growth. With its significant seat cost advantage this aircraft could be a powerful threat to the competing network builders operating smaller aircraft at high frequencies. These network builders are likely to respond to the launch of the A3XX with increasing mergers and acquisitions to gain the volume necessary to maintain a competitive position.
Due to external influences, no alliance is free to exploit the growth circle to its fullest advantage. Each individual airline either benefits from, or is hindered by, external forces, which limit their freedom to implement the ideal corporate strategy. Typical constraints include slot-restricted hubs, lack of ability to add destinations and frequencies, a need for new large aircraft, and a lack of adequate financial return. Potentially, alliances could experience a multiple of their members' individual constraints, all impacting their bottom line.
Different margins
The European and US carriers now achieve similar operating efficiencies, but even in 1996 - a strong year - the players experienced significant differences in their margins. The carriers' strategies and geographic locations strongly influence financial results, which in turn determine each player's long-term competitive position.
Generally, large congested airports allow higher yields than transfer hubs. While the airlines at Vienna, Copenhagen and Zurich still obtain relatively high yields, increasing competition will put great pressures on these airlines. Brussels suffers from low yields and high losses.
Congested hubs generally house volume operators with high capacity aircraft (BA, Cathay Pacific and Japan Airlines). Open hubs tend to house frequency/network builders lacking the unit cost advantages of high capacity aircraft. The Northwest-KLM cost data illustrate that a hub-building strategy demands the highest possible efficiencies to remain competitive. As competition leads to similar fare levels for all players and cost levels are largely determined by hub location and strategy, an airline's operating result is strongly influenced by geography and strategic choice. Operators at congested airports tend to be profitable, except in Japan which suffers from very high costs, while frequency airlines and hub builders report more variable results.
Slot restricted
London/Heathrow has been severely slot restricted for years, while Amsterdam and Munich have not suffered these limitations up to now, allowing their home carriers a relatively free choice in operating strategy. Whereas British Airways increases aircraft size per departure to accommodate growth, KLM can afford to operate smaller aircraft, focusing on frequency. BA has 212 seats per movement at Heathrow, while KLM has 129 seats per movement at Amsterdam (Table 1). Lufthansa is building up frequency and destinations at its new Munich hub using smaller regional jets; it averages 105 seats per movement at Munich. These distinct operational differences affect the nature of each airline and its hub competitiveness, as well as its ability to generate finance to compete in the longer term.
An analysis of OAG schedules data indicates that the strongest hub builders are United at Los Angeles, Northwest at Minneapolis-St Paul and KLM at Amsterdam, with twice the average growth in departures in combination with the largest reduction in aircraft size, while BA and United have opened new hubs at London/Gatwick and Washington/Dulles (Table 1). Capacity restrictions at Heathrow, Gatwick and Frankfurt are forcing the home carriers to increase aircraft capacity per departure.
All airline hubs are not equal, as they vary in the percentage of locally generated traffic. Local demand for air travel dictates the proportion of high yield point-to-point traffic at a hub. Hubs located near large business communities will have a higher proportion of point-to-point traffic than hubs located elsewhere. The advantage of locally generated traffic is that it is a captive market over which hub based carriers gain a degree of commercial control, raising yields.
Thus the most attractive hubs from a financial point of view are congested hubs near large business communities, as scarce resources lead to higher prices. London, Hong Kong and Tokyo are the best examples.
In order to be competitive with these congested centres, hubs located near smaller communities will excel in product quality and tend to be operational successes with high growth rates. But the high dependence on transfer traffic means lower yields, putting pressure on costs.
Alliances at pure transfer hubs, such as Amsterdam, Minneapolis, Munich and Vienna, need to obtain significant unit cost advantages over congested hubs while using smaller aircraft, a Herculean task. KLM-Northwest so far seem to have been successful at this, with the added benefit that their lower unit costs allow them to set prices.
In the transatlantic market, alliance competition focuses on price and frequency. The true strength of alliances lies in their ability to connect the individual networks in such a way that they become one. The aim is to achieve maximum connectivity among all stations at the highest possible frequency by linking the central hubs. Table 2 compares the ability of the alliances to compete in the transatlantic market over their respective European and North American hubs using a minimum connecting time of three hours.
Multiple connections
For example, Stuttgart has 22 transatlantic city-pairs in which all four alliances compete. American-BA offers an average of eight weekly connections between these cities, compared to Star's 32 connections, KLM-Northwest's 25, and Delta-Swissair's 20.
Chart 3 shows graphically how the four major transatlantic alliances each provide thousands of weekly double-hub connections between smaller destinations on the two sides of the ocean. One such city-pair is Gothenburg-Kansas City, where each alliance provides multiple weekly connection options (Chart 6).
Anti-trust immunity allows an alliance to operate as a single carrier. Assuming fierce competition exists among the four alliances on these transatlantic routes, fares are likely to be very similar. Apart from internal efficiencies, the most significant factors influencing the financial results will be the seat mile cost of the aircraft type, the cost of running the different hubs, and the share of high yielding point-to-point traffic on each sector.
Since London has the largest point-to-point demand at the highest yield, it should generate the highest income. However a London based American-BA alliance cannot match the higher frequency and transfer product offered by the other alliances. Statistical theory suggests that the alliance with the highest frequency gains the largest market share, and this explains the growth in transfer traffic seen at hub airports. Thus an American-BA alliance would have a strong financial position but would be (somewhat) limited to the US-UK point-to-point market as its competitive position in the US-European market would be relatively weak.
The virtuous growth circle indicates that larger aircraft provide a self-generating competitive advantage. Yet American and Delta successfully operate relatively small aircraft at high frequency across the Atlantic. They succeed because of the power of their hub and spoke systems, CRSs and frequent flyer programmes, as well as the operating efficiency of new, smaller long-haul aircraft.
A worldwide distribution system, in combination with a large number of destinations served from a central hub, creates a strong control over traffic flows. Powerful sales and yield management systems may actually offset any unit cost disadvantage of smaller aircraft.
Alliances are able to direct traffic to such an extent that flights become profitable in markets that hardly exist. Only 16 per cent of traffic on American's Manchester-Chicago flight is point-to-point. KLM and Northwest operate the Amsterdam-Detroit route three times daily in summer (two B747s and one B767), yet no service existed between these cities prior to the alliance. A direct service is not viable without transfer traffic, and today no fewer than 78 per cent of passengers on this route transfer at both airports, underlining the effect of network integration and the fast growing double-hubbing market. Successful network integration leads to higher growth, and this is well illustrated by the KLM-Northwest airports (Table 4).
The strength of an alliance lies in its members' ability to integrate their individual networks, creating a new single system which maximises on-line connections over their hubs (Table 5).
Heathrow is slot restricted and has suffered a loss of worldwide destinations, as British Airways moves intercontinental flights to its new hub at Gatwick. At Frankfurt the Star Alliance is number one in the number of destinations served worldwide, but second after KLM-Northwest in the number of uncontested routes.
As for traffic growth, Lufthansa's Munich hub is successfully gaining traffic as it builds up, but possibly at the expense of Lufthansa's Frankfurt hub, where traffic has been flat over the last year. Potentially, the Munich hub could take growth away from the main hub. This will halt seat-mile cost improvements and the Munich hub will have appreciably higher operating costs per seat and lower margins due to the use of smaller aircraft. Alternatively, Lufthansa could treat the two hubs as complementary and operate them as one. In that situation its market share could grow due to the increased frequencies, but long-term competitiveness could suffer as costs are relatively high.
Nonstop competition
The main competition for alliances comes from direct nonstop services which bypass hub transfers. All alliances are vulnerable to nonstop competition, so the strength of alliances must lie in their ability to connect unique markets which will not support direct point-to-point service by others. If alliances are to gain traffic volume faster than competitors, they must continuously develop new markets to protect themselves against the traffic lost to competitive hub-bypassing.
Here British Airways has a distinct disadvantage due to its inability to add new destinations, so its growth must come from the more competitive existing markets. Heathrow's Terminal 5 would definitely help to strengthen BA-American's position in existing markets, and the introduction of the A3XX would further assist the alliance by exploiting BA's cost and yield advantage over others.
Congested airports push alliances to become volume oriented operators, providing them with a unit cost advantage, higher yields and above average financial returns. British Airways is the prime example. However these carriers suffer restricted network growth opportunities, limiting their future scope.
Transfer dominated alliances like KLM-Northwest tend to be highly cost efficient, and seek high growth rates through network expansion in an attempt to gain volume faster than high volume carriers do. However the lower yields achieved by these operators result in continued cost pressures and more moderate financial returns.
In the end both strategies will lead to further concentration, as the significant income of volume operators will lead to predatory action by the richest players to gain new hubs, while the network builders will seek mergers and acquisitions to increase their volume in order to remain competitive.
Source: Airline Business
