The airline industry is renowned, with few exceptions, for its poor returns. Indeed, airlines as a group actually destroyed value between 1992 and 1997, achieving a feeble 6 per cent return on invested capital - at least three percentage points below the 9 to 10 per cent cost of capital in the industry.
Although the overall score is grim, not all players suffered the same defeats. Airlines fall into three distinct groups: the outstanding performers, the average players, and the also-rans. The stars, among them Comair, Atlantic Southeast, Cathay Pacific, Southwest, Northwest, US Airways, United and Singapore Airlines, have been making several percentage points over the 10 per cent cost of capital. Average performers with returns of 8 to 10 per cent include some of the biggest players such as British Airways and American. Astonishingly, more than half of a sample of 43 airlines had returns on capital below 8 per cent.
ANOTHER PERSPECTIVE
Looking at the situation from a different angle, the airline industry has a large number of participants in a value-added chain that leads to the final product for the customer. This chain starts with aircraft manufacturers and leasing companies, continues with providers of support services such as catering, ground handling and airports, and ends with distribution services such as computer reservation systems (CRS) and travel agents. To assess the state of the industry as a whole, we must analyse the financial performance of all the participants in the value chain: manufacturers, leasing companies, service providers, distributors, airports and labour.
The aircraft manufacturing and leasing businesses are, like airlines themselves, cyclical. But that's where the resemblance ends, because these other cyclical players have been able to achieve returns of 15 to 16 per cent on invested capital. Assuming that their cost of capital is similar to or lower than that of airlines, they have been making five percentage points above their cost of capital.
Service providers and distribution mechanisms, which are not cyclical, have also achieved several percentage points in excess of their cost of capital. Their stable performance means that their cost of capital is much lower, at 7 to 8 per cent. Most of these industries, once core activities for the airlines, have recently emerged as spinoffs or new ventures, and they have been able to capture substantial amounts of value. The CRS systems have been able to earn at least 20 percentage points above their cost of capital.
Airports, for the most part owned and controlled by governments, have also been a source of good returns. Indeed, large airports are such excellent businesses that governments tend to subsidise small airport infrastructures with the returns obtained from airports with heavy traffic flows. Privatised airports, like those managed by BAA in the UK, have a return of 17 per cent - at least five points higher than their estimated 10 to 12 per cent cost of capital.
Suppliers in the airline industry value chain are not the only ones making excessive returns, however. Airline workers, and in particular unionised personnel, are doing so too, limiting the return received by capital owners. During the last five years pilots, cabin staff and other crew have made an accumulated excess return of approximately $13 billion over and above what the market would have compensated them.
This assessment is based on the fact that it is possible to employ excellent pilots for much less than the normal cockpit cost in the US, Europe, and Latin America. Consider Deutsche BA and Crossair, which have pilot costs 40 to 50 per cent lower per block hour than those of the European majors. The low-cost airlines in the Mexican market provide another example. They have been able to hire pilots who have previously worked with other major airlines for less than half their previous salary, and have also achieved greater scheduling flexibility, reducing total labour costs even further.
When benchmarked with jobs outside the industry, crew costs are excessive. In Latin America, a flight attendant has a high-school education, works 58 hours a month, and enjoys 36 days' vacation per year. A marketing analyst on a similar salary would have a university degree, work 176 hours a month, and take no more than 12 days' vacation.
This surplus in crew compensation over the market rate can be attributed to the bargaining power of unions. In Europe, it is the southern European airlines that tend to give away most to their crew relative to local cost and salary levels; not surprisingly, these are also the players that have made the biggest losses for their shareholders.
EXTRACTING PROFITS
What all these cases have in common is that participants in the value chain have developed bargaining positions that allow them to extract profits at the expense of the airlines' capital owners. These players have done so because they are monopolies or oligopolies. Further, it is fair to say that airlines have become somewhat inattentive to the profits of their 'suppliers'.
Two aircraft manufacturers share the entire market for large commercial jets; two leasing companies together boast a 45 per cent share of their market; Sabre, Galileo, and Amadeus are each clear leaders in their own territories and collectively command a 90 per cent share of CRS systems worldwide. Airports are monopolies everywhere. Airport services such as catering and ground handling are virtual monopolies or oligopolies in their local markets, and are consolidating into global oligopolies with the emergence of players like LSG/Sky Chefs and Ogden.
Airline labour has also managed to become a monopoly. Unions and strict labour contracts have restricted airlines' access to a larger pool of talent that might be cheaper and more flexible. Together with the perishable nature of the airline product, this puts employees in a good bargaining position when they threaten to strike; as a result, they are extracting a disproportionate share of value.
While other industry players have carved out strong positions, airlines have managed to keep the risks all to themselves. Although it is no secret that cyclicality is caused by industry overcapacity, airlines have made things worse for themselves by owning the aircraft that are the source of the problem. An aircraft leasing agreement might seem to function as a risk-sharing mechanism, but in fact it does not serve that purpose: instead, airlines are bound by rigid contracts that compel them to keep an asset for a pre-established period at a fixed cost. Not sharing the risks of overcapacity creates a misalignment between the needs of capacity producers and those of airlines; aircraft manufacturers and leasing companies pursue increased sales in the short term even if the result is a downturn for the airline industry.
Regulators too have played a role in the distribution of returns in the value chain. Preoccupied with the monopolistic nature of airlines and their visibility to customers, governments have helped shift value to other players. Regulators scrutinise the way airlines behave in their negotiations with travel agencies and service providers, never realising that the latter are claiming more than their fair share of the value.
DUE SHARE OF VALUE
As well as battling it out with other airlines, a key challenge for an airline's managers is to ensure that their company and its capital owners receive their due share of the value added in the industry chain. Had airlines been able to capture the value of the other participants in the chain for themselves, they would have closed the performance gap and provided an adequate return on the capital invested in them.
To secure a fair share of returns for their shareholders, airline managements should take three steps: improve their bargaining position, share risk with others, and increase revenue potential by leveraging their current asset base.
IMPROVE BARGAINING POWER
An airline can improve its bargaining power in two ways: by increasing its importance to its suppliers, or by diminishing its suppliers' importance to itself. The second approach does not easily apply to providers such as aircraft manufacturers and leasing companies: their importance to an airline can be diminished only with difficulty, since they are few in number and irreplaceable. But the first option is still open: airlines can improve their relative position by increasing their size, and thus the volume of their purchasing. One possibility is to form joint purchasing alliances: an example is the Qualifier Group, in which five airlines (Swissair, TAP, Turkish, Sabena and Austrian) have developed a strategy to purchase their aircraft from one manufacturer. A similar effort is taking place among several Latin American flag carriers.
Bargaining power with service providers such as catering, ground handling, CRS systems and travel agencies can be improved by adopting both methods. First, just as with manufacturers, airlines can establish alliances to attain greater purchasing volume. The Qualifier Group operates in this way too, and illustrates how airlines with different standards of service can unite to improve their clout with catering and ground handling companies.
Second, there is no reason why service providers cannot be less important for airlines. Indeed, airlines can encourage competition by seeking alternative providers and being careful not to overspecify the service levels they require. Keeping broader service levels allows for continuous bidding, keeps switching costs low, and makes substitution a genuine threat for service providers.
The same goes for travel agents and CRS systems. Airlines must develop different ways to sell their product. As competition between the different distribution mechanisms intensifies, CRS and travel agents will see their excess returns shrink. Embracing technological changes such as ticketless travel and direct sales via the Internet gives airlines a way to improve their relative position in the value chain. Most US and European airlines have started down this road - Lufthansa with its Chip Card, Southwest with electronic ticketing and American with its Internet site - but thus far they seem to be passing much of their cost saving to passengers, missing the opportunity to improve their shareholder return.
Labour is no different. Unions have manoeuvred themselves into a monopoly position which airlines must challenge if they are to eliminate the excess returns enjoyed by certain labour groups. As well as being tough in face-to-face negotiations, airlines should develop a strategy to manage their unions.
One short- to medium-term action that management can take is to fragment the power of the unions by developing specialised operators, ideally with different unions, or at least with different labour contracts and independent negotiation set- ups. Along with better customer service and easier network management, this is a reason behind the creation of shuttles and low-cost and regional carriers by major European airlines. In the long term, airlines should aim to recruit from a large group of pilots rather than from the usual restricted pool of talent; this should be the ultimate goal for union management.
SHARE RISKS WITH OTHERS
In examining the structure of contracts between an airline and its suppliers, including employees, only seldom do we see an alignment of interests. Take airline manufacturers and leasing companies: in the short term, they want to sell or lease as many aircraft as they can. They are not overly concerned with airlines' capacity utilisation or fixed costs. Pilots are interested in flying as few hours as possible while retaining their salary levels.
Airlines can resolve these misalignments by sharing risk with other players. Consider the US railroad locomotive business, where railroads lease trains 'per hour of use'. It is thus in locomotive manufacturers' interests to optimise the total lifetime economics of the train. In the airline business, similarly, leasing companies and airlines could jointly try to minimise overcapacity. One airline that is setting an example is Tower Air, which was able to lease Boeing 747s and pay by hours of use, thus transferring the aircraft's utilisation risk to the leasing company.
A similar approach can be pursued in relation to the workforce. Providing employees with a piece of equity aligns their incentive system with the airline's economic interest. Bought out by its employees, United exemplifies the ultimate alignment between airline and workforce. Schemes like this explain why Air France's management negotiated hard to have its pilots accept a swap from cash to stocks in their salary.
LEVERAGE THE ASSET BASE
Airlines hold approximately 60 per cent of the total assets in the industry value chain, and currently use them in a focused way to transport passengers and goods. But this asset base could generate other sources of revenue if airlines put it to work to expand related businesses. Examples might include increasing revenues through codesharing, which doesn't entail incremental investments; expanding the use of call centres to make reservations for other businesses or to carry out telemarketing; and selling frequent-flyer programme miles to banks and retailers.
Airlines can also expand their revenues by leveraging intangible assets such as their brand name and relationships. British Airways' franchise system, which allows smaller airlines like Maersk and CityFlyer Express to use its name as an umbrella brand that assures the passenger of a certain level of service, is a good example. Finally, airlines can use their skills and capabilities to grow, perhaps like American looking into opportunities such as consulting or managing privatised airports.
MANAGE THE REGULATORS
Although there are many opportunities for airline management to help redistribute the returns in the value chain, little can be achieved unless regulation is addressed. Airlines must actively manage their regulatory environment. If an airline is trying to improve its bargaining power with suppliers, for example, its government should permit and support further industry consolidation.
Similarly, if the airline needs to curtail the power of unionised personnel, the government must take a stand along with airline management.
Two recent strikes illustrate what governments can do. In the Air France pilots' strike in May, the French government backed management's negotiation process even in the face of the pressures surrounding the World Cup. Similarly, when the Aeromexico flight attendants went on strike, the Mexican government stepped in and provided support to allow the airline to continue normal operations.
Finally, if airports are being privatised, the key will be to ensure that the privatisation scheme benefits airlines. Steps in this direction include managing fuel distribution as a cost centre and minimising landing fees.
RIGHTFUL SHARE
In the whole of the airline value chain, the only participants not making attractive returns are the airlines themselves. To capture their rightful share of the value, the carriers must set about restructuring the value chain to improve their own position within it.
In doing so, careful thought should be given to the structure and returns of the airlines' suppliers. Further, the significant excess return of labour groups should be challenged. Thirdly, the airlines should find ways to leverage their current asset base further.
It is right and proper that a greater proportion of the rewards from this business should be enjoyed by those enterprises which provide the capital investment and take the risk.
Source: Airline Business
