Airline Fleet Strategies: The Embraer Way

Brazilian aerospace major Embraer which is making substantial headway in regional aviation globally has been in the forefront of strategising not just for itself but also for airlines. In sync with this philosophy, Embraer released at the Paris Air Show, ‘The New Metrics of Success’ which provides fresh perspectives on airline fleet strategies. The report is dedicated to helping airlines confront and overcome the challenges of the aviation sector. The report begins with remarks from Warren Buffett who at a Berkshire Hathaway meeting said: “investors have poured their money into airlines for 100 years with terrible results.” Endorsing this somewhat, Embraer said that investing in airlines has commonly resulted in disappointment for shareholders – at least partly because of challenges inherent to the business.

Making a point, Embraer points out that the airline seat is among the world’s most perishable goods. Once the aircraft door is closed, all empty seats accumulate as waste. Hence, some airlines sell them at a very low cost to avoid their being flow empty, thus diminishing the airline’s revenue potential.

So the question is: how can the airline industry provide better returns for investors? Embraer believes such financial success is already emerging from a well-executed business strategy focused on the quality of revenue to boost results. And, from its global perspective, it is clear that the 70- to 130-seat segment can help bring sustainable profitability to the industry.

Pitching 70 to 130

A little over a decade ago, Embraer published ‘The Rule of 70 to 110’ — a rationale for a lower seat count that would help carriers right-size their capacity to match demand. It was the premise behind its E-Jet family of four. And now, with over 1,000 of them delivered and serving every continent, it is clear the rationale behind ‘The Rule’ was right. A second generation of E-Jets redefines its segment as 70 to 130 seats. “But the essence of our original vision endures, even though the dynamics of our industry have changed. A key example is the now-common focus of airlines on lower unit costs as a strategic advantage in the aggressive pursuit of market share.”

Embraer believes unit profit and return to shareholders are better measures of success. Accordingly, it supports the use of a new metric in conjunction with traditional measures: return on aircraft assets (ROAA), as distinguished from conventional ROA. This, Embraer believes, will be an increasingly important indicator for aircraft evaluation.

From market share to shareholder returns

In the competitive environment that emerged since E-jets were introduced, many airlines focused on lower unit costs as a strategic goal. Those carriers exalting cost per seat as their main metric have been left with no choice other than to reduce unit cost, in order to accommodate lower unit revenue, and then see their earnings erode. One result: a lack of service differentiation leading to partial commoditisation of air travel.

Empowered passenger

In parallel, dramatic changes in technology brought new levels of transparency that also changed consumer behaviour. With the benefit of online search engines, access to fare and seat availability has uncloaked the complexity of ticket-price categories. Consequently, consumers can pay for the products and services they value most. Their bargaining power is greater than ever before.

Vicious cycle

Some airlines in search of the lowest unit cost increased capacity and additional seats, which had to be sold at a lower price. As competition followed suit, market share battles began, which added more pressure to reduce unit costs, increase capacity, and therefore to lower prices even further. Lower costs brought lower revenues and not necessarily higher earnings — leading to a vicious and unhealthy cycle, the report noted.

To achieve positive margins, in hopes of escaping the vicious cycle, airlines have pursued ancillary revenue sources by unbundling and selling services that once were included in the ticket price. Ancillary revenue can increase profits and in some cases can mean the difference between profit and loss. But it is clear that the revenue boost isn’t always enough to ensure success. Which means the best strategies will seek maximum total revenue per passenger by maximising both average fares and ancillary revenues.

Largely because of intense competition and inherent challenges, average airline returns are seldom higher than the industry’s cost of capital. The current trend of improvement in returns is being driven by fundamental changes in management behaviour rather than by desperate cost-cutting. High asset performance is key to sustainable profits. “When you fly an airplane optimally sized to the market, the ROAA can be impressive. And ROAA is a more meaningful framework for making fleet decisions than unit cost.”

Measuring performance

When it comes to almost everything that can be bought or sold, prices are seldom the same. Consider the difference in price for a bottle of water sold in an upscale restaurant versus in a supermarket. The explanation is willingness to pay; people place different value on the same service. When it comes to air transportation, there are fewer passengers willing to pay more, and more passengers willing to pay less, for the same seat. Airlines adapt to capture the value they create for various passengers by creating different fare classes, as in the following example.”

In this comparison between a 110-seater and 170-seater, based on a simplified example of revenue optimisation, a market share driven strategy would welcome additional passengers attracted by price incentives, yet overall yield would be diluted since excess capacity would be allocated to the lowest fares. On a leg basis, a smaller airplane will have higher revenue per seat than a bigger one. The magnitude of this difference will depend on individual market factors, but simulations run by MIT and PODS Research (USA) indicates that a 30 per cent advantage for the smaller aircraft is widely applicable to our example of 110-seater vs. 170-seater. Subtracting cost per seat from revenue per seat yields profit per seat, mostly higher for the 110-seater.