Alliance strategy in one form or another has come to dominate the airline landscape. Yet while such major structural change may be crucial for the long term, it is not a universal panacea for airline ills. The industry's more immediate well-being lies elsewhere: in the mundane business of generating cash and profits. It is on that score, rather than the sophistication of their alliances, that carriers will be judged - not just by financial analysts, but by their bankers and investors.
If that is true, then the greater danger for most carriers in these uncertain times is how well they balance the complex relationship between yields and capacity and how well they judge the interplay between the economy and "underlying" traffic growth. It is not the dash to build market share.
As has been demonstrated through countless previous cycles, simply buying share by the pound may achieve no more than profitless growth rather than providing a platform from which to dominate a market. But the temptation is never far away.
Europe provides a case in point. Last summer, real concerns had begun to surface over the extent of capacity increases and attention was being focused on how it might be cut back if fears of a sharp downturn became real. Despite further signs of slowing economic growth, so many carriers are once again preparing to raise capacity at a significantly faster rate than that of underlying traffic.
Forging alliances provides no immunity from such temptation. In fact, there is a danger that they may be every bit as prone to engaging in self-defeating market share battles. In the short term they may be more so.
Alliance rationale
The rationale behind airline alliances is reasonably straightforward: to increase revenue and - perhaps more importantly for profits - reduce cost. Over time the cost savings should indeed significantly outweigh the benefits from initial revenue gains.
So while Lufthansa reports that it made gains of over $250 million from alliances in 1998, this stemmed mainly from the revenue side. But it also suggests that in 1999 this will be boosted by costs savings of some $80 million. Similarly KLM's Focus 2000 programme appears increasingly dependent upon the realisation of cost savings to reach its targets, given the near-term expectations for slower revenue growth.
British Airways and Qantas are already showing gains from "capacity co-ordination" on routes between Europe and Australia - in that case not only saving on aircraft acquisition but reaping a secondary benefit of yield improvement as capacity more closely matches the "natural" or "underlying" market.
But while alliances may hold future potential for serious cost gains, they are still in their infancy. Almost by definition, the deeper the partnership the stronger the gains. Reaching that depth takes time. Consequently, after an initial "kicker" to profits the lasting benefits from an alliance will be slow to show through to the bottom line. As a rough calculation it may take five or six years for an alliance to start reaping its maximum benefits.
The fastest way to realise the gains is inevitably through progress to a full-blown merger, but barring a sudden change of heart by the regulators, that seems some way off. Instead, the industry will have to settle with halfway houses. The need will also be to develop workable management structures that will clearly give rise to first and second tier partners.
There are also significant labour issues that will have to be resolved. Some are beginning to materialise, threatening to have major impacts on the flexibility of crews to work between partners. Action by the KLM pilots' union during the Northwest strike is a clear sign.
So while cost gains remain difficult to achieve, the alliances are likely to remain heavily reliant on the more immediate benefits to be made from the added revenues which flow from increased market presence and traffic feed. But this comes with a warning: success in the airline industry cannot be measured simply in terms of absolute market share. The real questions are how that share is won and how to keep it profitable.
The right market share
For certain, the answer to success does not lie in simply flooding the market with capacity in a one-way bet that competitors will withdraw and price leadership can be established. Whatever the market simulations show, it will be a painful option even if it succeeds. Regulators are hardly likely to stand on the sidelines if it does.
Neither is success becoming any easier for the traditional flag carrier. As the rise of Southwest and its low-cost followers has demonstrated, when barriers to entry diminish so does the ability of the incumbents to control price and, to varying degrees, cost-driven pricing takes over - with the obvious consequences for those whose costs are not low enough.
In any case, the search for the "right level of market share" may be a hopeless quest, at least for the traditional flag carrier. For a start, it is not a stationary target. The real market is starting to be re-defined, in terms of geography and segment. Despite a tradition of providing all-embracing services, the airline business, as with so many others, is beginning to see the script rewritten around a number of separate market segments. In short, airlines can no longer be all things to all men. They need to decide what they do best and focus on that.
There are naturally some significant issues to address over how an airline goes about making that transition from where it is today, towards where it needs to be to maximise profit potential. Ultimately there is no universal template - perhaps only a number of realistic guidelines to bear in mind for those hoping to make the journey profitably.
Redefining the market
Alliances clearly represent an agent of major structural change in the marketplace. They allow a major partner in the region to extend its reach by tapping into additional traffic flows - effectively increasing the scope of its "home market". For their part, the "local/feeder" partner gains access to a network of new destinations. As a consequence the nature of traffic flows will change for both over time.
There are a number of related impacts which are particularly important, and go part way to the virtuous circle where the potential in the wider home market is maximised and the amount of targeted traffic that leaks to a rival network is minimised. The key focus here is access to key corporates, the pulling power of loyalty programmes and corporate offers.
While it is fundamentally important to earn and retain customers rather than simply buy market share, the nature of the individual corporate deal is clearly important. Indeed, alliances enable individual airlines to offer a world wider than their individual network - a development which applies not only to the "home airline", but also to competitive alliances. Here the need is to achieve the greatest presence and loyalty among the home-based corporates.
What is the "appropriate" market for which the virtuous airline should be aiming? Although there have been recent worrying comments from some about the desire to regain "lost" market share, there is at the same time an increasing realisation that not all passengers are profitable. Indeed, there are welcome signs and actions from other quarters sharing a determination to focus on real rather than stimulated traffic.
What then of attempts to regain "lost" market share? Competitive reaction is inevitable but are the gains from "fare wars" adequate to justify the course of action? Is revenue in the airline industry only a function of volume? The answer is a definitive no. Neither is revenue growth a necessary and sufficient condition for profit increases - and most definitely not for the full-service flag carrier.
The real objective must be to maximise the rate of growth of the most remunerative market segments. For the "mainline" airlines this means locking in the maximum flow of business traffic from a widening home market, particularly the need to flow long- haul passengers through the network.
British Airways, for example, has a significant benefit in Europe, since some 65-70% of its long haul traffic is made up of lucrative origin and destination (O&D) passengers. With any revenue management/capacity control system, the key is to maximise the achievable yield. Clearly for BA the most remunerative yields are from long haul point-to-point premium travellers and so BA seeks to be the airline of choice in its own home market. The next most remunerative set of passengers are premium passengers transferring to and from long haul flights which produce a yield some 2.5 times that of O&D economy traffic.
Consequently, as BA increases its effective home market through alliances, increasing the potential to feed its long haul flights out of London, its traffic structure changes and its dependence upon low yielding traffic reduces. Furthermore it shows quite clearly the reason for a focus on smaller long haul aircraft and also the rationale behind expanding the size of the premium business cabin.
In essence BA is beginning to focus on the real growth of its potential market rather than seeking to stimulate it. That comes after last year's painful lesson, when BA hiked capacity by an over-optimistic 12%, only to find itself scrambling to fill seats and suffering a devastating change in mix as premium traffic weakened markedly. The scars are all too evident on its financial results for 1998/9.
In a weakening market, the damage should hardly have come as a shock. Looking at BA's performance over the past 15 years, there is clear relationship between raising capacity and falling yields. The same trend line could be drawn for many others.
Perhaps then the conclusions to the debate over the appropriate level of market share should be as follows:
* There is no magic number for market share - the real need is to maximise the profitability of the achieved and achievable market share, in what is the realistic market.
* The need and importance to retain customers - winning and in particular regaining lost customers can be expensive
* So far, alliances have resulted in a redistribution of existing traffic rather than real market growth.
* An ideal objective is to create a situation of excess demand in each relevant market where it is uneconomic or impossible for competitors to enter, and then to focus attention on providing capacity for the underlying rate of traffic growth rather than needing to fill aircraft by resorting to market stimulation.
If the capacity equation were not delicate enough, there is the backdrop of a downturn in the world economy. While the West may yet avoid the outright recession that has swept through Asia, it is clear that all forecasts point to a slowing in economic activity. As the airline industry knows to its cost, when economic growth loses its force as a traffic driver the market has to be stimulated by low fares producing a disproportionate collapse in yields. As in the in the last downturn, this can have dramatic consequences for profitability as airlines seek to fill capacity rather than fulfil demand.
Economic slowdown
That experience suggests that the industry's ability to match capacity with real demand in a downturn remains elusive.
It is true that the trauma of the last downturn has produced a much more realistic approach to capacity within the industry as a whole over the past few years. At the same time the importance of replacement capacity has also increased. The positive benefits were evident as operating margins swung from record lows to highs. The question now exercising minds is how to avoid a repeat of that roller-coaster when traffic again eventually slows.
The USmajors are adamant that they will not fall into the same trap again. BA too appears to have learned its lesson, indicating that it will peg capacity growth at only 0.6% in the current year and plans cuts by 2001/2. Similarly, KLM has cut back its planned capacity increase to just 2-3%.
However, elsewhere in Europe there are more ominous signs. Air France, Lufthansa and Swissair have already revealed plans for significant capacity growth this year. Lufthansa recently outlined an increase of close to 10% rather than the 6-8% that markets had been expecting.
A further worrying dimension is that the increases in capacity are in part to gain/regain market share with clear consequence not only for yields but for profits too if progress on the cost front fails to keep pace. Even with the best of intentions there is little insurance against a rise in those costs over which a carrier can exert little direct control. Fuel price is a case in point. It is giving a massive fillip to profits, but stands just as capable of swinging back in the wrong direction.
The effect that sudden inflows of capacity can have on a market was all too evident last year when a number of the Asian carriers started to shift seats onto new international routes. The result was to destabilise these new markets with a concomitant impact upon yields.
The success of any actions taken in isolation are a direct function of the control that the action taker has over their own destiny. As airline markets become increasing open and liberal in terms of access and capacity so the relative importance and balance of the competitive dynamics will change again.
In such a situation, it is possible to borrow lessons from physics as well as economics. To each and every action there is a more or less equal reaction from the competition. In economic terms, fighting for market share with excess capacity, especially against a slowing market background, will move an industry, which even in its better times operates in an environment little better than one of "knife edge stability", into painful disequilibrium.
Perhaps, one day, alliances will make airline markets a little more robust, but until then it may be wise to follow that piece of homespun airline wisdom: you can chase revenues or yields - but not both. n
About the author
Chris Tarry joined Commerzbank in May as its Global Airline Analyst after spending almost 11 years with Kleinwort Benson. During his time there, the key annual surveys among financial investors have consistently ranked him among the top three European transport analysts. He also led the marketing of a number of airline privatisations including the 1997 Lufthansa sale.
Commerzbank is working with Airline Business to build an economic model of the industry which aims to provide an important leading indicator to the future financial health of the key markets and carriers. The AB Index will appear in future editions of the magazine, addressing many of the issues contained in this article.
Source: Airline Business
