Airlines - Watch Your Weight

Owing to the airline industry, millions of people each day can count on speedy, comfortable and safe journeys to their chosen destinations. Swift and affordable air travel helps oil the wheels of international commerce and is a catalyst for globalisation. Few businesses can claim to be as important as commercial aviation for the smooth and efficient working of a modern society. Few industries can claim such dramatic improvements in operating performance, either. According to International Air Transport Association (IATA) figures, over the last decade alone, there has been a 71 per cent increase in labour productivity, a 20 per cent gain in fuel efficiency, and a seven percentage point improvement in load factors. Then why does the airline industry currently seem to be in the throes of a life-threatening crisis?

The figures for 2008 are staggering. Hit by the double whammy of skyrocketing oil prices during the first half of the year and global recession during the latter, the world’s airlines notched up a collective loss of $10.4 billion (Rs 50,500 crore). Faced with falling demand, collapsing yields, plummeting consumer confidence and the spreading swine flu pandemic, they fear a further loss of $9 billion (Rs 45,000 crore) this year. Indian carriers alone account for $2 billion (Rs 10,000 crore). Although depressing, these figures could well be underestimated. Most airlines across the world cut capacity, squeezed costs, fired staff—and yet reported deficits. In fact, the airline industry as a whole has made a cumulative loss during its history, if the costs of aircraft development and airport construction are considered.

Sickness & Size

Airlines can be categorised as intercontinental, intra-continental, domestic, or international and may be operated as scheduled services or non-scheduled charters. Historically, the airline industry has survived thanks largely to government support, whether in the form of equity or subsidies. To this day, many airlines are state-owned national airlines. Even fully private airlines are subject to a plethora of government rules and regulations for economic, political and safety reasons. Governments are pleased to see airlines flying their flag and are generally willing to sink in ever more money to keep them afloat. Reason being national pride would presumably be hurt if the country’s airline were to fold up or, worse still, be taken over by a ‘foreign’ entity. Consequently, few other industries have ever enjoyed the speed and scale of assistance that the US Congress offered domestic airlines post-9/11.

Some ‘airlines’ may consist of just one aircraft ferrying mail or cargo. At the other end of the spectrum, full-service international airlines operate hundreds of aircraft daily. And while the huge US Southwest Airlines fleet consists only of the Boeing 737 and its derivatives, the now defunct US Eastern Air Lines operated 17 different aircraft types, each with varying pilot, engine, maintenance, and support needs. Fielding the right-sized airliner is vitally important. Too large an aircraft can leave many unsold seats sloshing around the market each day, despite the cut in fares; too small an aircraft could mean lost revenue opportunities.

In a recession like the current one, small airlines are often the first to go under. It has long been assumed that the best way for a sick airline to survive is for it to be acquired by a profitable one. Consequently, around the world there are several large airlines. However, it is unclear how mergers and acquisitions can solve the problems of insufficient revenue and high costs which lead to inadequate or uncertain profit. Experience has shown that airline mergers are often costly and messy. They need considerable post-acquisition activity where revenues are improved but with a significantly reduced cost base. The less-than-happy Kingfisher-Deccan union as well as Jet Airways’ tortuous acquisition of Air Sahara should give even the most ardent advocates of airline mergers food for thought. As for alliances, they can also act as virtual mergers to circumvent government efforts to regulate monopolies. Although they reduce some of the costs faced by airlines, they also entail additional financial burdens. Forming the alliance may impose costs on account of negotiation as well as additional administrative items. Standardisation of activities between participating airlines in an alliance may also increase operating expenses, at least in the short term. The jury is still out on the efficacy of the strategic code-sharing agreement that Kingfisher Airlines entered with Jet Airways last year.

Merging small airlines into larger ones is often promoted as a means of consolidation. However, consolidation in a market can also occur through exit and that is sometimes preferable. Currently, across the globe, there are too many carriers and too much capacity. As has happened so often over a century of commercial aviation, aircraft that were aggressively ordered in good times are once again being delivered in recession—when these are somewhat less than welcome. About 4,000 aircraft are scheduled for delivery over the next three years, which amounts to 17 per cent of the current global airliner fleet. Finding passengers to fill them profitably is likely to prove a major headache even for the brightest brains in the industry.

Scale Effect

The case for ever larger airlines rests mainly on the principle of Economies of Scale. Airlines are labour intensive. Each major airline employs an army of flight crew, maintenance personnel, ground handling staff, reservation agents, security personnel, managers, accountants and lawyers. Perhaps a third of the revenue generated each day by the airlines goes towards compensation for its people. Human resource costs are among the highest in any industry. Therefore, increasing passengers on an existing route (whether by increasing the number of filled seats on a flight or by increasing the number of flights) often leads to lower unit costs. Another method to reduce average operating costs is by increasing the number of routes - the same workforce, within reason, can then handle the additional traffic. In a merged airline, theoretically, fewer employees can handle the existing traffic, since overlapping functionaries can be fired. However, if Air India’s merger with Indian Airlines in 2007 resulted in any reduction of staff, it is a closely guarded secret. This ill-starred marriage has resulted in an 800 per cent increase in their combined losses in just two years.

Airlines incur a high level of fixed and operating costs in order to establish and maintain services. While conducting day-today operations and maintenance in an economical and effective manner, they need to have in-built flexibility to rapidly adapt to changing market conditions. They need to purchase or lease new airliners and engines regularly and make major long-term fleet decisions, aiming to meet the projected demand of their markets. And they daily live with the knowledge that even the best estimates may turn out to be woefully off target. Airlines also need consistent profitability to satisfy their huge requirements of capital. Because they own large fleets of expensive aircraft which depreciate in value over time, they typically generate a substantial positive cash flow (profits plus depreciation) which they use to repay debt or acquire new aircraft. When profits and cash flow decline, an airline’s ability to repay debt and acquire new aircraft is jeopardised. But what dominates the discourse at numerous airline board meetings and management conferences is the break-even load factor.

Don’t Break Up, Break Even

Large or small, most airlines typically operate very close to their break-even load factor—the percentage of seats that must be sold at a given price to cover costs. The sale of just a couple of extra seats per flight, on the average, could transform a lossmaking enterprise into a profitable one. While setting fares, airlines strive to maximise their revenue by offering the right combination of full-fare tickets and discounted ones. Too little discounting in the face of low demand, and the airliner could take off with a large number of empty seats. On the other hand, too much discounting can sell out a flight far in advance and lose last-minute passengers who might be willing to pay higher fares—another lost revenue opportunity. Sophisticated computer modelling is now available to help airlines price their tickets right.

Ticket prices have indeed been the key to the airlines’ success for years; lower ticket prices obviously generate a greater demand for flights. Which other industry has so many ‘special offers’ and ‘never before’ deals? For instance, it is estimated that more than 90 per cent of the tickets sold by US airlines are discounted, with discounts averaging two-thirds off on full fare. Fewer than 10 per cent of US passengers pay full fare, most of them last-minute business travellers. The airline industry is also well aware that most passengers, particularly those on holiday trips, have a host of alternatives. They can choose to drive, take a bus or train, select a nearby destination or just stay at home. While business travellers sometimes have no choice but to fly, many companies have found substitutes such as surface travel or virtual conferences. Many short-distance travellers are migrating from flights to trains which generally unencumbered by security checks, are less hassle and cheaper. As a result, questions are increasingly being asked about the future prospects of the airline industry. What kind of fares will the airlines need to charge to survive even if higher tariffs mean fewer passengers? Here, perhaps, large airlines have some advantage since they possess deeper pockets but, as even Kingfisher Airlines would know, every debt has to be honoured some day.

Airlines worldwide also seem to be falling over each other to embrace the low-cost model. These include Indian carriers like Kingfisher Airlines and Jet Airways who had declared, in the not-so-distant past, that the low-cost model was not viable as more than two-thirds of an airline’s operating expenditure, including fuel, landing and navigation charges, lease charges and maintenance costs, is fixed. But lowcost is hardly a foolproof solution. Low-cost airlines often recover just 50 per cent of their operating costs through passenger fares. They need very high load factors to break even, generally more than 80 per cent. For instance, Ryanair, the leading low-cost airline in Europe, has been consistently averaging load factors of above 80 per cent for some years and touched 89 per cent in July. Knowing that such stratospheric figures are difficult to achieve with regularity, most low-cost airlines count on passengers to buy extras like food or use a mobile phone or pay to check-in luggage or even to use the rest room. Finally, desperation sets in and fares are raised in an attempt to stave off disaster. In the recent Indian experience such fare increases have often been badly timed, leaving passengers wondering about the rising fares even with fuel prices falling.

Living On The Edge

Is larger better? According to the Airline Business rankings, the best margins for 2008 were achieved by smaller carriers. Of the 15 best performers in this field, none ranked above 25 in terms of revenue. Instead it was Kuala Lumpur based low-cost airline AirAsia which led the field with a remarkable 28.6 per cent margin. AirAsia has a fleet size of just 75. Chris Tarry, one of the leading aviation analysts in Europe, marvels that while other industries increase profits through growth, airlines do not. Despite flying many more customers than in the past and serving many more destinations, airlines are no more profitable now than when they were much smaller. “Airlines are filling up more seats, but the number they have to fill to break even, has grown. This is profitless growth. A lot of airlines are on knife-edge instability,” he says. It is the same story in India where many experts feel that airlines in India grew too big too fast.

The global financial crisis has left scores of airlines, large and small, reeling. Many have already folded up or commenced bankruptcy proceedings. The survivors have initiated savage cost-cutting measures. Whilst programmes to cut costs are a necessary reaction, there are a number of non-negotiable items including safety-related expenditure, customer service, brand promotion and the minimum essential network. Cost reduction also needs to be undertaken with an eye on the future. It must not compromise the ability of the airline to take advantage of the upswing whenever it occurs, despite the immediate temptation to save cash.

Airlines operate in highly competitive markets and cannot escape risk. In fact they are unlikely to grow or even succeed without taking risks. But trying to achieve the right balance between risk and reward is just as necessary. Here airline size could prove crucial: too small and the enterprise could lack the financial muscle to weather even moderate turbulence; too large and decision making could be hamstrung and slow to respond to change.