For decades, airlines have struggled to ride out the peaks and troughs of the industry's rollercoaster business cycle. Witness the damage done to profitability during previous downcycles at the start of the 1980s and even more dramatically again in the early 1990s. With another such downturn already overdue, the question now is whether the industry today is better placed than in the past to cope if and when it finally arrives? And what strategies, if any, can airline groups adopt in order to offset the worst of the damage? In particular, that raises the issue of how far, if at all, airline managements should seek to spread risk through diversification.
The industry may not have too long to wait in finding out just how well their strategies will work. Indications are that another downward turn in the cycle may indeed have been triggered as the world entered the new century. Airline profits have been on a plateau for the past three years or so and are currently under increasing pressure, as shown in the latest financial returns from both the US and European majors.
Significantly this recent fall in profitability is being blamed on different causes than those that have typically induced a slump in the past. This time the focus is on costs - in particular higher fuel prices, further aggravated outside of the USA by high dollar exchange rates.
Traditionally, industry downturns have centred on a classic boom-to-bust model of supply outstripping demand. During the boom years of strong demand and profits, airlines have been encouraged to expand capacity beyond the long-term rate of demand growth. A spree of aircraft ordering, such as that in the late 1980s, sees manufacturer backlogs soar. Then, just as deliveries begin to peak, another trigger event launches the downcycle - in that case the Gulf crisis of 1991. Once load factors fall, the first airline to really suffer from the squeeze on cash flow starts to drop yield levels and others consequently follow.
Early indicators
A reliable early indicator to where the industry stands in this cycle has, in the past, come from the "surplus fleet"- defined as the number of aircraft in the market above that required by all operators assuming optimum utilisation. Whenever the surplus fleet has grown above 8% of the entire active fleet, the industry has experienced a downcycle. Recent forecasts suggest that this trigger level is not likely in the near future. This is based on the assumption that orders for additional capacity will start to decrease considerably during 2000 compared with the past few years, and that the retirement of Chapter II aircraft will gain momentum. So will these two assumptions hold good?
So far this year, there has not been too much evidence that airlines have actually changed the pace of their aircraft ordering. However, the bitter lessons of previous downcycles have encouraged carriers to negotiate reasonable cancellation clauses into their order contracts. That has considerably enhanced their flexibility to stop deliveries should demand falter. Airframe manufacturers too have a vested interest in avoiding the worst excesses of the cycle by smoothing out deliveries. And what of the expected pace of aircraft retirements? The recession of the early 1990s should have been mitigated by promised retirement of older, noisier aircraft, but in fact these were taken up by the low cost start-ups and other second tier carriers instead .
If the baseline assumptions are changed, then the forecast does begin to look less comfortable. If retirements fail to rise above 1999 levels then the industry may sail close to the trigger point for a downcycle. And if deliveries fail to fall from 1999 levels over the next four years, there is little doubt that this would represent a classic case of market oversupply.
Even if classical drivers are not applicable in today's market, there are still myriad bridges to be crossed. Fuel price hikes and exchange rates are already being felt. Last but not least, there is political instability in many corners around the world. There are also structural changes taking place within the industry itself. The arrival of new Internet marketplaces has brought with it new levels of speed and transparency. The continuing march of deregulation also continues, bringing in its wake a new breed of low-cost competitors.
Those themes have already played themselves out in the deregulated US market. Now it is the turn of Europe and Asia to watch new players enter the markets. Additionally, the industry has been undergoing an unrelenting wave of privatisation, while in Europe, at least, regulations have limited the degree to which states may subsidise their flag carriers. There are no longer safety nets available for those that fail to make it through the next cycle.
How to manage the cycle?
For those that do wish to engage in some cycle management, the basic task is straight forward:to make it through any future cycle in an orderly fashion, with steady cash flow and continuous growth. But there are two fundamentally different strategic approaches that could be followed to achieve such an objective. The first is to concentrate on the core competencies of the existing business, but look for ways to reduce the stress of the cycle. The second tries to escape from the industry cycle entirely by diversifying into unrelated businesses or hedging against the financial impact of a downturn.
The apparent advantages of diversification are clear enough. Proactive investment into non-related industries has been a popular strategy in many sectors for companies keen to stabilise shareholder cash flows. Such diversified groups, whether Japanese conglomerates or US holding companies, are well know. A clear example in European aviation came from the SAS group, where chief executive Jan Carlzon tried to develop a broader scope of non-airline-related businesses in the 1980s.
However, looking at the portfolio of today's airline groups, there are few if any examples of broad diversification. Carriers have either committed to their core business and so intensified their exposure to the cycle, or otherwise "diversified" into related risks such as logistics or catering services. This may simply reflect the fact that most senior airline executives have grown up in the industry and wish to expand the business within their area of competency.
Besides putting a damper on the cycle effect, the key challenge of cycle management is to avoid the worst case scenario - a loss of liquidity. So if an airline's competitive situation and debt/equity ratio would not provide sufficient financial backbone to overcome a downcycle, then neither would it be strong enough to justify investment in unrelated businesses.
State-of-the-art financial engineering tools might, however, be an alternative. Airlines could hedge against the cycle as many already do against fuel or currency risk. By using appropriate derivatives, carriers could invest cash flow from the good years into options that pay out depending on the overall industry's performance - or rather lack of performance - in the bad years. An industry profitability index, or perhaps more simply a representative stock index, could form the framework for this type of hedge program. This is definitely something worth thinking about.
However, at this point, it is worth raising another good argument against seeking to diversify, either through non-core activities or financial derivatives. The reason is that shareholders may not welcome it. Many would prefer to manage risk themselves through the spread of their investment portfolios. Pension funds and other financial investors even see their core added value in mixing non-correlating business risks. If they hold an airline stock then they do so with the full knowledge of the accompanying risks and rewards. They do not need an airline board to manage that risk on their behalf, especially if it also dampens the reward.
Corporate strategies have therefore tended to evolve away from the prevailing diversification and portfolio approaches of the 1970s and 1980s, towards a focus on core competencies and "parenting advantages". The core value proposition for any corporate holdings is that they make a neat strategic fit with the markets and resources of the parent group.
Practical approaches
In terms of how to go about stabilising the core business, the airline industry has witnessed three distinctive strategic patterns over recent years:
Focus on the core (passenger) business and ensure a lean cost structure Horizontal product divisions by spinning cargo off as a separate profit centre Horizontal and vertical product divisions by additionally transferring internal support functions to profit centres and aiming at gaining a foothold in third party markets.The business structure of selected leading global airlines outlines the three distinctive approaches (see Illustration 4 left). An analysis has been carried out to see whether the development of these groups of airlines differs significantly compared with the industry's average, characterised by Air France, the one airline in the sample that comes closest to average.
In the first group are three US majors together with British Airways. These have chosen to focus on the core passenger business, with cargo considered a by-product of earnings contribution. Fleet development is fully driven by passenger market needs and full freighters are employed on wet lease - if at all. Support functions such as engineering or catering are geared up for in-house requirements only, or even divested. The spin-off of BA's engine shop to General Electric and of its catering facilities to Gate Gourmet are popular examples.
Outsourcing of support functions enables fixed capital investment and human resource costs to be converted into variable expenses. Orders can be adapted to actual needs much more easily than facilities and employees. Maintenance and catering have little market potential beyond serving airlines and can therefore be expected to follow the same business cycle. Although mid-term commitments have to be made at the take-over period, in the long run the freedom of choosing ( and squeezing) the supplier base improves the impact on cost and quality. That is specifically true for those functions that are not considered to be strategic core qualifications.
Singapore Airlines and Cathay Pacific provide the best examples of the second strategy pattern, with freight standing alongside passenger as a profit centre. This has not been driven by any strategic aim to reduce the impact of the airline business cycle, but rather by the role of Hong Kong and Singapore as Asia's main gateways for exports. Local governments have always supported the role of their home carriers to serve the export industries. Both Cathay and Singapore Airlines run considerable freighter fleets and are among the leading global air cargo carriers in terms of freight ton kilometres carried on international routes. Both airlines have also engaged in support functions, but maintenance and ground service activities remain highly focused on their home bases.
The next group centres on those carriers which have sought to make considerable contributions from building up business units beyond passenger and cargo markets. Those are showcased by Lufthansa and the SAirGroup as well as Japan Airlines(JAL).
JAL has built its non-traffic activities on the travel and hotel business to the point where they account for close to 25%of the group's total turnover. Meanwhile, SAirGroup and Lufthansa have changed their whole organisational structure into the form of holding companies, where former support functions like maintenance, catering, ground services and IT are managed as separate business units. Each has the goal of positioning itself as a leading global player within the relevant market. LSG Sky Chef and Gate Gourmet are today's global leaders in the in-flight service market; Lufthansa Technik and SAir Technik achieved similar positioning in the third party maintenance markets; GlobeGround and Swissport have built up operational bases around the world; finally come Lufthansa Systems and ATRAXIS in IT.
One might argue that through this approach, Lufthansa and SAirGroup actually risk increasing rather than lowering their exposure to the business cycle. Once the airline industry hits a down-cycle, support functions will suffer not only from reduced orders but also from contract renegotiations initiated by a client base searching for opportunities to squeeze costs. So, a diversification effect can hardly be expected. Key drivers of the strategy seem to lie elsewhere, namely in avoiding the social conflicts that would arise were the units to be outsourced, while at the same time creating an entrepreneurial spirit within the business units which did not exist when they were fully captive.
Does diversification pay?
So which if any of the three approaches is the most successful in avoiding the damage done by the down cycle? To answer this question, operating margins for the three distinctive clusters have been plotted over time. For comparison, average figures were calculated based on the individual airline's annual operating margins for the three groups.
These figures show that the three US airlines and BA have developed very much in line with the industry cycle. In fact, their operating margins have followed an even stronger cycle than the industry average. During the last downcycle in the early 1990s, their results were below industry average while, during the later up-cycle, their performance was above average. Cathay and Singapore Airlines, who developed their share of cargo business considerably, suffered a severe setback due to the Asian crisis in the late 1990s whereas JAL managed to improve its operating margin during the same period. JAL's performance matches the overall performance of its cluster with Lufthansa and SAirGroup. To demonstrate, but to highlight its distinctive track during the Asian down-cycle, the Japanese carrier's operating margin has also been plotted individually for 1995-1999.
Interestingly, the third group seems to correlate the least with the most recent downturn of the industry's operating margins. This might seem surprising considering the rationale discussed. However, although internal group negotiations of transfer prices are often considered as non-value-adding, the internal business culture at Lufthansa and SAirGroup today compared with the way they worked ten years ago clearly demonstrates that change has been remarkable. Internal customer orientation, a rigid unit cost mindset and shareholder value perspective are the new rules of the game. These factors all indicate that the initial business unit concept is successful.
Of course, other determining factors have to be taken into account and the small sample within each cluster can hardly be taken as a representative group for the distinctive strategic approaches. Additionally, latest trends in supply and demand, in load factors, and in operating margins in the industry airline cannot be interpreted as a genuine down-cycle yet. However, until now, initial hypotheses have not been substantiated that the outsourcing of support functions will help airlines out of the vicious industry cycle. It will be interesting to see how the industry as a whole and the three clusters develop in the near future.
Source: Airline Business
