(Part II – Technical Analysis)

In a previous article (26 September 2011), we highlighted the challenges of aviation and showed how this often misunderstood industry is striving for a better future, after 60 years of poor performance. In this second and final part, we indicate some basic strategic choices, backed up with a brief financial analysis of the industry, using some well-known economics frameworks and management concepts.

A business with high variable costs (eg. a small shop) has fairly stable – or at least, predictable - profitability. Most of its expenses would be the cost of goods and labour as well as rental and utilities, without much capital tied up. If profitability turns consistently negative, exit is quite easy, without incurring much capital loss. A company in a high fixed costs industry (eg. telecoms), however, will probably not show any profit for its first 100,000 customers. It requires heavy investment in infrastructure before it can start to sell. But thereafter, a high part of its revenue will consist of profit. Aviation is blessed with neither of these situations. The industry has to manoeuvre with relatively high fixed costs and … high variable costs. Volatility also means high risk. Airline strategy is thus more challenging.

High Degree of Operating Leverage (DOL) – Airlines have to support high costs for aircraft acquisition or leases and mandatory maintenance. Other substantial costs are the requirements to satisfy stringent safety and security regulations in the form of high insurance premiums as well as heavy business processes. The silver lining in this scenario is that the marginal revenue from an additional customer should contribute to a higher profit margin, once fixed costs are covered. Imagine the telecoms company. When most of its infrastructure, licensing, branding and financial costs have been covered, a larger proportion of its marginal pricing (the revenue gained from an additional customer – hence the term ‘marginal’) are, in fact, mostly profit. This happens with airlines, but to a lesser extent, since airlines also have high … variable costs! High fuel price (and its variation) increase operating risks. Hedging can control this risk to some extent. Also, modern Revenue Management (RM) algorithms are programmed to fill a plane as much as possible, starting many months before the flight actually takes off. Nevertheless, an airline’s business (sales and operating) risks are intrinsically high. Let us now look at financial risks.

Debt – High fixed costs requirements also mean a high likelihood of resorting to debt, simply because more capital is required in the airline industry compared to say, the software industry. A high gearing (debt-to-equity ratio) increases financial risk. Risk premium increases on capital markets, contributing to a higher marginal cost of capital. This may be partly offset by operating leases (as opposed to financial leases) on aircraft, which reduce balance sheet exposure. A fixed financial cost thus turns into a rental expense. Airlines are also exposed to currency risks. If you buy Airbus in euros and sell tickets in euros, there is no foreign exchange risk. However, if you buy fuel in US dollars whilst earning revenue in euros, then there is currency exposure. Some state-owned Arab carriers would, in all likelihood, not have a high cost of capital and/or debt burden – to the dismay and criticism of some well-established major airlines. However, one may argue that if ‘old’ industrialised countries used their colonial networks to start their aviation industry, why would Arab countries not use the oil they own outright for the same purpose?

Magnifying effects of a downturn – Unfortunately, leverage also works in reverse. If a profitable airline enjoying high load factors loses passengers to competition – or simply due to a recession - its profit will shrink very fast indeed. In addition, aviation grows around twice as fast as the economy. So, in the case of a downturn, demand will shrink twice as fast and the airline quickly goes from being profitable to breakeven point and then, further beyond, into losses. These powerful levers act in the same direction (negatively in a downturn), making aviation a highly cyclical industry. Hence, our hint on airlines being ‘trading’ stock in the previous article.

Privatisation – The above shows that managing an airline is a rather complex business! It is therefore critical to be focused. Privatisation during the last 30 years has enabled airlines to concentrate on the microeconomic principle of maximising shareholder profit whilst delivering essential customer service. Even major airlines have adopted this business model as a means of survival, let alone for profitability (eg. British Airways).

Increasing competition – Larger players should increase industry concentration and hence give back pricing power to airlines. However, globalisation has brought in more players. The industry is now more competitive. Monopolies and duopolies first gave way to cartels. With European or American majors fighting the new Arab carriers, real competition has at last, belatedly, reached the airline industry. Instead of having a few airlines cosily fixing fares on a few routes (11 airlines including Air France/KLM, BA and Qantas were fined a total of €800m in 2010 for price fixing, taking illegal advantage of a cargo oligopoly), now fierce competition exists between, say, Lufthansa and Qatar Airways (and a very entertaining war of words between their respective CEOs!). The real game is to lower total cost by increasing passenger-km flown and hence lower unit cost. Medium-size players are condemned to grow bigger – or disappear. Mergers or acquisitions are one strategy as shown by the recent mega-mergers (AF/KLM, BA/Iberia, AA/Continental). In this light, imagine the challenge facing small airlines. Compare Air Seychelles to Emirates – or can we?

Less loyal consumers – The internet, competition on quality, price wars, refusal of bad service all contribute to transfer pricing power to the consumer. Passengers are now very sensitive to a change in price or in perceived quality. In economics terms, ‘elasticity of demand’ is now greater since there are more substitution possibilities (various competitor airlines for long haul and even high speed rail for short haul). Together with lower fares, as an industry moves from monopolistic to pure competition, ‘economic profit’ shrinks. When the difference between marginal revenue (MR) and marginal cost (MC) is high, other players enter the market, attracted by high ‘economic profit’, which increases supply and … reduces the ‘economic profit’ gradually to zero. It does not mean negative returns but a normal return – when pure competition is attained. At equilibrium (a point which competitive forces push towards), MR would equal MC. The producer surplus no longer exists.

Strategic choice – In a monopolistic or duopolistic world, airlines were artificially shielded from these dangers. They benefited from ‘economic rent’, at a high cost to consumers. With more competition, what should be the response? We can venture a first strategic pointer. A player in a high fixed costs industry and low pricing power is stronger the larger its size and the more efficient it is. In terms of microeconomics, if opportunities to differentiate are limited (or costly) or all possibilities with Marketing have been exhausted, the best course of action is to divide (ie. spread) Total Fixed Costs (TFC) with the most number of units produced (seats flown with passengers or passenger-km). One reason why Air Austral (let alone Emirates) has ordered the A380 is to gain economies of scale and hence lower unit cost. Indeed, they have even configured their mega-A380 as full economy class only. It is really about creating a super-efficient, cheap ‘highway’ between Paris and La Reunion. Low unit cost has to be achieved first, only then can cheaper fares be offered in a sustainable way. Airlines can also downsize their plants (aircraft) to reduce variable costs due to seasonality. So a large airline can try to fit the right size of aircraft for each route. A smaller airline is less flexible. Also, airline strategy being so complex, many forward looking players have sold their hotels, catering, cleaning and real estate businesses to concentrate only on striving to run an efficient airline. These ad hoc businesses are mere management distraction at best. Low cost airlines outsource maintenance to more specialised providers and go even further in focus: a real low cost airline is only a pure short haul business since long haul is an entirely different (and more complex) proposition.

The competitive environment is now very fierce. High oil price co-exists with competitive fares. Airline management is intrinsically complex. A government-owner (unless a hands-off one, which is quite rare), by definition, would not have the vision, the goals of efficiency, the analytical firepower or even the capacity to react - let alone a pro-active attitude. Would civil servants on the board of an airline understand that this extremely challenging business is all about lowering fixed costs (FC), tackling variable costs (VC) to reduce overall total costs (TC), improving organisational/HR efficiency, optimising marginal revenue through Revenue Management and Network Planning … whilst seeking differentiation and loyalty through Marketing at the same time? Air India, the airline probably with the best opportunity on its doorstep with national economic growth of 8%, remains dogged by internal and government politics. After being around USD1bn in the red 2009-10, its losses are expected to increase to USD1.4bn this year. If in traditionally profitable industries, mismanagement or a downturn reduces profit margin from 15% to 5%, in the airline industry, performance goes from 5% to minus 5% (at best). It is a make or break situation. This is why many airlines still show very volatile performance.

Fouad Diouman
fdiouman@hotmail.com