Europe's airline industry has traditionally been characterised by monolithic national carriers with strong links to their national governments, a lack of competition on routes, prices, and services, and little emphasis on the bottomline. Not surprisingly, these airlines, with a few exceptions, have not even earned their cost of capital.
But change is in the air. Deregulation is beginning to open up previously protected markets and to create competition on the basis of price and service. Governments, for a variety of reasons, are starting to give up ownership of their national airlines. Restrictive ownership rules are being dismantled, allowing foreign airlines to buy stakes in formerly national carriers. And Brussels is getting tougher on governments within the European Union that want to provide subsidies to their airlines each time they get out the begging bowl. When deregulation is completed in 1997, any EU airline will be able to fly anywhere within the single market and to compete in nearly all service activities, such as ground handling, catering, and check-in.
Moreover, non-European players are beginning to compete in markets previously reserved for national companies. Most notable among them are carriers from North America, which have now been able to increase their European presence. Independent ground service providers, such as Ogden in ground handling and Caterair in catering, are also increasing their coverage of European airports. This has meant that traditional sources of profit are being eroded, greatly diminishing the ability of an airline to subsidise its flight operations through revenues from other activities.
A new game plan
It is not clear how these changes will play out or what shape the European airline industry will adopt some years from now. Looking to the US, with its 15-year history of deregulation, provides some clues, but no firm conclusions.
Since the 1978 Airline Deregulation Act, US consumers have benefited from real price falls of an average of 20 per cent, and up to 35 per cent on long-haul routes. If European airlines respond to regulatory changes in the same way as their US counterparts, we are certain to witness a transformation of the industry in at least two ways: increased market orientation, leading to a proliferation of new services, and growing price and cost pressures, making productivity improvements a key factor for success.
The financial performance of most US carriers, however, suggests that many of their tactical moves since deregulation have not really improved profitability. The building of large networks on a hub-and-spoke basis, the aggressive marketing of frequent flyer programmes, the sophisticated use of yield management techniques and pricing systems, major investments in reservation systems, and even a constant focus on cost reduction - all these have been useful, even essential. But the higher productivity and investments in greater capacity have not been met with a commensurate increase in demand.
Some of these tactics may be relevant to particular European airlines, but they are clearly not for all to emulate. What is needed, instead, is a new game plan that will allow these airlines, most of which currently perform all activities from check-in to engine maintenance, to restructure around core activities. This will allow them to optimise the three critical levers of value creation: revenue enhancement, cost reduction, and reduction of asset intensity. Table 1 describes the activities performed by airlines today, as well as what will be required if they are to concede some activities.
Enhanced revenues will flow from airlines getting better at managing core competences like pricing, capacity, networks, and schedules. Those that dominate their home markets may need to exercise their potential clout by, for example, improving their marketing to frequent flyers and by experimenting with the design of travel agent incentive programmes. Many will also need to optimise their networks around their hubs.
Better cost management will mean that, in addition to making general productivity improvements, airlines will address the huge current disparities in crew costs between large, medium-sized and regional carriers. It also means they will be taken advantage of and that airlines will increase their use of related service providers, whose cost structures are significantly lower than those of airlines themselves. Asset utilisation will be improved when airlines begin to adopt a systemwide perspective on their fleets. In practice, this means reducing the variety of aircraft and splitting off non-core service functions such as engine maintenance and ramp services activities, which confer no competitive benefit but can tie up as much as 30 per cent of an airline's assets.
New roles
These levers of value creation are especially important, given the forces driving the industry's restructuring in Europe. There is an opportunity to transform market share into a long-term advantage in revenues through the use of loyalty programmes (with individuals, agents, and corporations), innovative pricing structures, and the control of distribution channels and systems - as well as through creative scheduling of airplanes.
Moreover, there is an opportunity to cut costs by having the actual flying done by the operator most able to do it at the lowest cost and an acceptable level of service. The goal is to share the benefits of scale, scope, and specialisation in core activities as well as such non-core areas as maintenance and catering. Table 2 outlines the impact of all major cost drivers on an airline and the importance and implication of tackling them.
The result of these forces will be not an industry that looks basically the same, but one with fewer players. The roles these players will fill are themselves changing. In the years ahead, we believe there will be three different roles among which the remaining participants in Europe's airline industry will have to choose: network manager, capacity provider, and service provider. Each of these roles offers a different route of access to the critical levers of value creation: revenues, costs, and assets.
Of the three roles, the network manager's is the most crucial and most complicated. Essentially, a network manager will orchestrate airline traffic and take ultimate responsibility, both financially and operationally, for business with the customer. His objectives will be twofold: first, to enhance the revenue-generation capability of the network so that it is perceived as having the best destinations, schedules, product quality, pricing, distribution, and customer and travel agent loyalty in a given market; and second, to optimise the cost-efficiency of the network by managing a range of partners that have excellent cost structures.
In essence, the network manager will perform the 'brain' functions of the airline, integrating network and product design, scheduling, yield, pricing, brand management, and sales, while purchasing both 'flying' and 'non-flying' services from other providers or suppliers.
To be a successful network manager, an airline must have preferred access to a market big enough to provide traffic for a global network. It must also possess advanced marketing and cost management skills. European airlines like Air France, British Airways, and Lufthansa, by the sheer size of their home markets, are already in a position to prevail as network managers. Others, like KLM and Swissair, which operate out of hubs such as Amsterdam and Zurich that are parts of global networks with more capacity than their local market can support, can also perform as network managers by continuously importing traffic from other markets. Airlines that have limited intercontinental or even Europe-wide routes but dominate their national markets will have to ally with network managers that are interested in exploiting the market potentials these carriers control.
It is conceivable that, with network managers focusing on orchestrating traffic systems, all non-core flight operations will be provided by capacity providers - different organisations with differing capabilities for performing specific tasks. These providers include, for example, feeder/commuter carriers flying to a network manager's hubs on routes with less traffic. Passengers then connect through these hubs with other flights coordinated by the network manager.
Among capacity providers will also be the secondary carriers that operate through specific airports that belong within a network manager's control. Such carriers are useful in situations where a network manager wants a tailored labour contract or management practice to apply or where operations are better undertaken by a capacity provider not used elsewhere in the network. Charter airlines might participate, too, especially when the network manager can benefit from having a separate unit making available a particular product (such as fleet or in-flight service) tailored to a specific market, such as leisure travel.
Typical functions of capacity providers will include supplying local network management, flight and cabin crew, and customer service, as well as overseeing the operational dispatch of planes. Most of the marketing, however, will be performed by the network manager. Use of capacity providers allows an airline's cost base to be reduced and the utilisation of its fleet assets to be improved. Capacity providers can, for example, permit a network manager to service a local route at the local cost rate, something that would not have been feasible with the economics of a major airline.
Non-core functions, from cleaning to the technical maintenance of a fleet, will increasingly be performed by service providers. In Europe, most of these services are currently performed either by the airline itself or by a wholly or partially owned subsidiary. Some major airlines have already outsourced their catering. There is, in fact, already a tremendous dynamism in this industry. Similarly, airlines often have a business interest in their maintenance service providers, although they are increasingly looking to third-party support. Ground handling, too, is mostly a local business dominated by national carriers and airports. Little is contracted out to third-party providers at present.
Yet the benefits of sourcing from third-party providers could be significant. Independent caterers, for example, pay wages at that industry's rates, rather than at the airline's, achieving labour cost savings of as much as 30 per cent. Thus, using these providers across a network and allowing them to compete for third-party work on other networks can build substantial economies of scale. Selling off current assets - in, say, engine maintenance - to service providers will also bring in cash infusions that can be used more productively elsewhere.
To work successfully with capacity and service providers, network managers will need to develop a range of skills that are not always present in today's European airlines. They will, for example, need to develop network optimisation skills on a multi-hub (rather than just home hub) basis and be able to perform such network management tasks as alloting slots to flights from all capacity providers, building in buffers to allow for last-minute changes within the network, and optimising aircraft and crew utilisation for the entire network - not just for a single capacity provider.
Network managers will also have to build the skill to sell the capabilities of the whole network, as well as to control relevant aspects of pricing and yield for all the flights they manage. In addition, they will have to develop good contracting and interface management skills, which will help encourage providers to deliver their services at the agreed quality and cost. And they will have to direct the focus of their traditionally volume-oriented local salesforces toward pushing what is right for the network, rather than what makes sense for an individual capacity provider. In order to avoid having to own their capacity providers, network managers must devise appropriate incentives to ensure that the right behaviour for the capacity provider is also the right behaviour for the network as a whole.
To capture the full benefit of capacity providers, network managers will need to develop a brand concept and a hierarchy of brands that leverages key attributes across the entire system while avoiding brand dilution. Many US airlines have successfully managed to develop sub-brands on their feeder or commuter lines. Examples here include American Eagle, Delta Connection, and USAir Express. In Europe, too, similar brand concepts are developing, with many airlines - like Lufthansa with its Express, Cityline, and Condor; SAS with SAS Commuter; and Swissair with Crossair - expanding their services through capacity providers connected via a brand hierarchy.
To avoid dilution, however, brand differentiation must be used to manage customer expectations. Distinct products such as business class, full-fare economy, and economy are given distinct brands such as Upper Class, Mid Class, and Economy on Virgin Atlantic, for example. At the same time, the core attributes - such as frequent flyer programmes, quality of flight attendants, uniform, logo, interior decor, in-flight entertainment, and terminal service - that transcend specific product differences are managed so as to attract customers to use the airline's portfolio of services.
Airlines today are organised to manage branding within their parent organisation, but are generally less skilled in - and less attentive to - managing the brands of their capacity providers. This is a mistake. When customer expectations are properly managed and fulfilled, quality differences between the parent and capacity provider have little or no negative impact on customer satisfaction.
The transition from current industry structure to a network-managed structure is bound to raise concerns in the workforce about changes to labour agreements, cuts in pay, route transferrals, contracting out and loss of seniority. Low-cost capacity providers, for instance, have cost positions less than half those of major airlines.
In response, airline unions are already coordinating international representation and forming cross-airline relationships to enhance their bargaining power. The International Transport Workers Federation, which is focusing more and more on the airline industry, supports a coordinated response to its restructuring initiatives. Airline unions are also linking up with representatives of capacity providers (Iberia staff with Viva, for example) to protect working conditions and wage levels. They are also forging links with global partners - as in the agreement over protection protocols between the unions of KLM and Northwest - even in advance of airline alliances. All indications suggest that airlines - some of which are still wedded to old fashioned, confrontational styles of management - will need to develop new, more sophisticated skills for managing employee relations across an entire network.
If network managers are to maximise the systemwide benefits of capacity providers, there will have to be a high degree of coordination and control. Up to now, European airlines have mostly been buying equity stakes in their capacity providers and increasing their stakes in recent years in an attempt to gain control, despite the considerable barriers to full ownership.
But majority stakes are neither essential nor desirable for control. Demonstrating competence in optimising systemwide benefits, showing clearly how this creates value both for the system and for the capacity provider, and defining the entrepreneurial challenge for the capacity provider - these are what matter. Even when the process is not transparent to providers, incentive mechanisms can be devised to allow the surplus developed by a network manager to be shared with capacity providers. Such incentives range from a transfer payment for each passenger delivered to the system by the capacity provider, which bears the remainder of the business risk, to a straight wet lease of a plane, in which the network manager buys the entire capacity and bears all risk.
Equity stakes are advisable, however, when network overlap is minimal and the network manager cannot create the natural incentives that are possible within a single system. Even so, it is useful under such circumstances to examine the specific reasons for taking an equity stake. One valid reason is to pre-empt competitors establishing a threatening position. Equity stakes may also be warranted when incentive schemes become so complex that neither side understands them. In addition, an equity stake can, at times, earn an attractive return for the network manager as a straight financial investment.
For these new roles to be successful, individual players in the system will need to earn adequate returns. Most of the value in the industry will be created by the network managers, and they will retain most of the economic surplus. This is because their fixed costs are increasingly becoming variable, as well as because they have to compensate capacity and service providers only as far as is necessary in order to secure their services.
Not everyone can be a network manager. Some providers - feeder/commuter airlines, say, offering highly substitutable services - will be squeezed, earning superior returns only when they demonstrate truly distinguished cost management. Services that operate within local duopolies - for example, ramp service providers, which will be restricted to two at most airports because of infrastructure limitations - will make decent returns as long as their services are cheaper than those offered by national carriers. Healthy returns will also be generated in services that offer advantages of scope or scale, such as catering.
These, then, are the new realities of the airline industry in Europe - not a decade from now, but today. The forces described above are already at work, and the reconfiguration of activities into the three core roles of network manager, capacity provider, and service provider is already underway. The time for choice is at hand.
Source: Airline Business
