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The Passenger Air Transport Industry

Par

G1313(GB)

Daniel HAUMONT Paris Dauphine University

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The Passenger Air Transport Industry Case Study By Daniel HAUMONT Paris-Dauphine University [email protected]

© CCMP 2004 – Air Transport Case - by Daniel Haumont – Université Paris IX Dauphine All rights reserved

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The Passenger Air Transport Industry Summary Introduction

page 3

1- Positioning the air transport industry within the overall business

page 3

2- The Passenger Air Transport Industry in the coming ten years?

Page 3

2.1 Status

page 4

2.2 To survive

page 4

3- The complexity of the Industry

page 5

3.1 Regulation – Deregulation

page 5

3.2 The Hub-and-Spoke model

page 6

3.3 Yield Management

page 7

3.4 The Global Distribution Systems (GDS)

page 7

3.5 Alliances

page 8

3.6 Business travellers and Fidelity programmes

page 8

4- Airline COSTS

page 10

4.1 Wages

page 10

4.2 Aircraft Maintenance

page 10

4.3 Airports

page 10

4.4 Fuel and Oil

page 10

4.5 Air Traffic Control (ATC)

page 10

4.6 Catering

page 11

4.7 Flight planning

page 11

4.8 Ground Handling

page 11

4.9 Insurance

page 11

5- The aircrafts: present and future

page 11

6- The alternatives to flying with a Scheduled Airline

page 13

7- The distribution system: The role of travel agents

page 14

8- The two main business models

page 15

8-1 The Flag/Network Carriers (Majors)

page 15

8-2 The “low cost” airlines

page 16

8.3 The competitors

page 16

Conclusion

page 19

Questions

page 19

Internet sites

page 20

© CCMP 2004 – Air Transport Case - by Daniel Haumont – Université Paris IX Dauphine All rights reserved

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Introduction The overall Air Transport contributes for $1400 Billion to the world economy (equivalent to 14% of the US GDP or equivalent to 90% of the French GDP); it employs 28 million people worldwide. This Industry started in the 1930’s in the USA with William Boeing (1886-1955) who after launching successfully Postal services across North-America thought that there was a future for passenger aircrafts. From 1915, with more or less success, he developed different types of military and postal aircrafts most of them partly financed by the American State. William Boeing was not an engineer; he was really business oriented and service oriented; in the 1920’s he had already a vision about the future of civil aviation. In 1932 William Boeing created an Airline which later on became United Airlines (presently, in year 2003, under US Chapter 11 protection), after having been for decades one of the major airlines in the US, and from 1978 in the world. The first passenger aircraft was able to transport 8 passengers; later on, W. Boeing invented the job of aircraft cabin crew (the first one was a nurse). William Boeing’s Empire was dismantled in 1936 on request of the US Government stating that it was not fair (antitrust) that the same company be an aircraft manufacturer (civil and military) as well as a postal service provider and a passenger service company. William Boeing abandoned the business for ever immediately (He came back for a while as a “patriot consultant” during World War II). In Europe, the first “line” was in 1919 between Berlin and Weimar (the new capital after World War 1); in 1922, the first airport was in Königsberg (Kaliningrad in Russia at present) because this German territory, after World War 1, was isolated inside of Poland. 1- Positioning the air transport industry within the Air transport overall business The ROC (Return On Capital) of the different industries related to air transportation are: •

Aircraft manufacturing: 16% (Two majors: Boeing, Airbus)

•

Leasing: 15% (Two majors)

•

Airlines: -3% (1500 airlines worldwide)

•

Ground Handling: 11% (less than 3 competitors in deregulated airports)

•

Catering: 10% (Two majors have 40%)

•

Airports: 10% (Natural Monopolies)

•

CRS (Computer Reservation Systems): 30% (Four competitors worldwide)

Source: MIT/Aèroplan Ltd 2- The Passenger Air Transport Industry in the coming ten years? From the figures above, it is clear that the Passenger air transport industry is not very profitable on a long term basis. How to make money in such an industry, even in favourable circumstances? The low values of the airlines (their shares) on the stock exchange are explicit in this respect : all the airlines quoted on the New-York Stock Exchange are worth $50 Billion in February 2004. The Railways are worth $67 Billion (thanks to the freight).

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2.1 Status According to René Lapautre, former CEO of UTA French Airline acquired by Air France in 1989 and now Consultant for the Industry, it will not be quite different from what it is today. There is no revolution in view. The last one took place in 1969 with the first Jumbo Jetliner (Boeing 747); the previous one occurred in 1956 with the first large passenger Jet: the Boeing 707, able to divide by two the time required to cross the North Atlantic ocean. From 1995 until early 2001 (the downturn occurred before September, 11th , 2001), the air transport was quite prosperous, each year being better than the previous one; all the airlines were acquiring new aircrafts from Airbus and Boeing. From 1995 to 2000, airlines earned profits of $39 billion and acquired 4,700 jets. Suddenly in 2001, orders were cancelled and a lot of aircrafts are now awaiting better circumstances in deserts; Arizona is the biggest site. In 2003, aircrafts in surplus were about 13% of the total fleet (Source: McKinsey Quarterly 2002). The same type of crisis, although to a lesser extent, occurred in the 1990’s. According to the past statistics it occurs approximately every 10 years. There is a bubble (1988) followed by a crash – 4 years of losses - (1989-1992), then a slow recovery (1992-1995) and the real recovery (1995-1997). The air transport industry is very sensitive to the economy; should the GDP growth be limited, even without being in real recession, the industry would be suffering. The net margins, when they are positive, are thin in this business. When the cost of the oil, which represents approximately 13% of the operating cost under normal circumstances (oil barrel around $20 to $25), increases rapidly, then the margins become negative for the majority of the airlines. However, the airlines use hedge facilities and derivatives (financial tools) to offset the issue. The main reason for this occurrence is the high operating costs of the Flag/Network Carriers or former Flag/Network Carriers, now public. The words “Network Carriers” are also used for the large airlines. These airlines, most of them, even though they got rid of the control of their State shareholder, kept high cost by not making enough efforts to externalise activities which were not part of their core business … and due to relatively high salaries and strong Unions (for United Airlines, 50% of the operating cost consists in wages). On the other hand, when the natural traffic growth averaged 15% in the 1960’s, 10% in the 1970’s, 8% in the 1980’s, it is now around 4%. It seems that it is going to stabilize under the present “normal” circumstances. The demand growth was directly geared by the GDP growth : a GDP growing by 3% creates a demand growth of 6% (twice the GDP growth). Considering the last 30 years, the yearly demand growth has been 6% with an average GDP growth of 3% per year. In developing countries like China, the yearly GDP growth might be around 7% and thus the airlines passenger traffic might increase by 14%. 2.2 To survive, it is mandatory that the existing firms in this industry find new travellers. In the U.S, there were about 80 airlines in 1982 after the expansion which followed the 1978 deregulation; in year 2003, there are about 40 airlines which survive, and, out of these 40, there are only 5 or 6 Majors operating both domestic and transcontinental flights. The consolidation of the industry is much more advanced in the U.S than in Europe where there are 160 regular airlines (non charter) operating 2000 aircrafts vs. 40 regular airlines in the U.S operating 4600 airplanes. Where to find these new travellers ? For the so called “low cost” airlines (Southwest, Ryanair, easyJet, JetBlue …), there is a clear target, it is based on the marketing concept of price elasticity … and it works. But, for the Flag/Network Carriers, their present high costs are the problem; can they afford to be price competitive without losing money ?

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The efforts of the companies are facing additional costs proceeding from the airport authorities, from security requirements, from en route navigation, from insurance … For the Flag/Network Carriers, 15% of the passengers are Business Class passengers, however, they represent 40% of the revenues. On the other hand, the Flag/Network Carriers manage, on a limited number of segments, to compete on a low price basis (however, without low cost). Despite of the advantages they had from their Flag/Network Carriers status, some of them went bankrupt in 2001: Sabena, Swissair. In such a context, can the rules of the game be fundamentally changed without a real innovation in the industry ? The Alliances between companies from different geographical horizons to cover the world are a defensive strategic tool (more details further in the text). The Hubs aim at concentrating the regional traffic on a limited number of large platforms in order to feed the long haul flights. Hubs are also a defensive strategic tool: an efficient one! However, Hubs have a high operating cost (more details further in the text). Only a political decision might change the rules of the game; this is what President Carter did in the US in 1978 with DEREGULATION. It took place in Europe 15 years later in 1993. Bilateral agreements still exist between airlines to share city pairs; however, a new entrant can operate on the same city pair if it can obtain the “slots” it needs to operate from the airports (a “slot” is an authorization to park a passenger aircraft, at a given airport, for a certain period of time and with a certain frequency). Even on the North Atlantic segments, there are still traffic limitations. Low cost airlines like Ryanair seized the opportunity and use secondary airports to bypass the “slot” scarcity. The automotive industry succeeded, to a large extent, in lowering drastically its costs; is it feasible for the large airlines? 3-The complexity of the Industry The Passenger Air Transport Industry is a complex one; understanding it requires studying various aspects and their links. These aspects are covered in the following paragraphs. 3-1 Regulation / Deregulation Since the beginning of its already long history the Air Transport Industry has been regulated. In the 1920’s when William Boeing managed to launch its Postal Service using its own Boeing aircrafts; he was constrained to fly from Seattle (the city where Boeing manufacturing was created) to Vancouver (Canada) because US domestic postal flights were the monopoly of the Federal Government. In the late 1920’s, when the system became unmanageable by the authorities, Boeing was finally authorized to offer postal domestic services. He developed the postal Boeing company by the way of acquisitions of US postal operators. With the time, more and more regulations were set, substantially limiting the traffic rights. Each country was willing to have its Flag/Network Carrier. Even a small country like Luxemburg has its airline (Luxair) … Luxemburg (250,000 inhabitants) has had a University only since the beginning of the 21st century! Such a number of airlines creates a highly fragmented market which is not prone to be cost efficient. But with the bilateral agreements, usually a city pair was served by only 2 airlines agreeing on a high price; tickets were transferable; therefore, there was no need to be cost efficient, due to the lack of competition. A niche segment appeared in the 1970’s with the charters. Only a few countries authorized charter flights to operate from them (often small countries like Iceland, Luxemburg ...).

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Only a political decision was able to change the rules of the game; this is what President Carter did in the US in 1978 with the DEREGULATION Act (any airline, in the US, can fly anywhere). DEREGULATION appeared in Europe 15 years later in 1993. Bilateral agreements still exist between airlines to share city pairs; however, a new entrant can operate on the same city pair if it can obtain from the Civil Aviation Administration “slots” in the airports (easyJet obtained slots in Paris-Orly in 2002) . A “slot” is an authorization to park; this authorization is given by the Civil Aviation Authorities of each country to the airlines, according to more or less clear attribution rules; chauvinistic aspects exist and the Flag/Network Carrier is not the less favoured. Low cost airlines like Ryanair seized the opportunity using secondary airports to bypass the “slot” scarcity. Subsidisation of airlines by the governments was stopped in 1991 in Europe. But there are still some conflicts (EEC against Olympic Airways and the Greek Government). After September, 11th , the US Government took the political decision to subsidise US Airlines for an amount of $15 billion. The rights for a foreign airline to transport passengers in a country are still highly controlled. For instance, Air France or Lufthansa cannot transport passengers from a US city to another US city (Cabotage). In 2002, the EEC Justice Court based in Luxemburg cancelled the “Open Sky” agreement passed by 8 European countries and the USA; this country to country agreement allowed reciprocal traffic between two countries to the only benefit of the airlines of the 8 countries. With the “Open Sky” agreement Lufthansa was not authorised to fly from Paris to New-York. The EEC Commission wants an agreement between EEC countries as a whole and the USA. In ASIA, DEREGULATION does not exist yet. There are bilateral agreements: for instance 8 European airlines fly to China and 3 Chinese airlines fly to Europe. An airline of a given country must have a majority of its shareholders from that country; this is true for most of the countries and for all the large countries (foreigners cannot have more than 49% of a European airline and 25% of a US airline). This prevents consolidation of Flag/Network carriers from different countries. This is argued as a national security problem; but in fact it is a form of protectionism. However, the Air-France/KLM merger was accepted in 2003. 3-2 The Hub-and-Spoke model The Hub model (1978) is a consequence of the deregulation process. In order to face a much more competitive industrial environment, it was necessary to find a solution: networking was the solution. However, the passenger airlines did not invent the Hub concept. It was developed in 1976 by a freight airline: FedEx; FedEx implemented for its airline what it had already implemented for truck transport. Principle : A Major airline is operating a central platform: its HUB, and Commuter airlines feed the Hub with passengers proceeding from regional airports located at a distance of about 350 km to a distance of up to 1,500 km. So, large aircrafts can reach load factors high enough to make the flights profitable: productivity gains were shared between the airlines and the passengers. These commuter airlines which were operating turbo-prop aircrafts are now operating 40 to 70 seats regional jets; these small jets can be filled with enough passengers without discounted fares making them price/cost effective. The commuter airlines are often units of large airlines or linked to them by commercial agreements. The low cost airlines depending on the airports they are operating from can be a threat for Flag/Network carriers since they connect cities directly. 3-3 Yield Management (Revenue Management) © CCMP 2004 – Air Transport Case - by Daniel Haumont – Université Paris IX Dauphine All rights reserved

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Principle : The airline industry strives to maximize the revenue obtained from the sale of tickets on every flight. This is referred to as yield management and it forms a crucial aspect of airline logistics. In order to fully benefit of the Hub concept, it was mandatory to manage the capacities efficiently. Ticket pricing, seat or discount allocation, and overbooking are some of the important aspects of a yield management problem. For Air France, 210 staff are working on Revenue Management dealing with 18 million tariffs and 620000 flights per year. The Yield Management idea was born in the U.S; it is based on several considerations: •

Seat Reservation

•

Management of “classes” of reservation (tariffs) according to the moment the reservation is made vs. the flight departure date/time.

The objective of this marketing tool, which is also used for the trains now, is to maximise the revenue proceeding from each flight. It is a complex matter which requires a mix of maths and marketing. Deliberate overbooking is a practice which proceeds from Yield Management. The statistic number of “No shows” passengers is taken into account. “No shows” passengers are passengers which have made a reservation on a flight and decide not to fly as they planned without telling the airline to cancel their reservations. It is very common in Business Class. Yield Management is a technique which can be used for any industry when the inventory is perishable. 3-4 The Global Distribution Systems (GDS) or CRS (Computerised Reservation Systems) Global Distribution Systems appeared in the early 1980s; they are one of the consequences of deregulation. They allow any travel agent to access at any time the inventory of the airlines reservation systems and to make bookings. From mid 1960s, airlines have had Reservation computers; this industry, with the banking industry, was one of the first to use real time computers. They were able to make passenger reservations by using terminals far from the main host computer through leased telephone lines. From 1969, they have been in addition, using a cooperative message switching network operated by SITA (Société Internationale de Télécommunications Aéronautiques) to access their Reservation computers from many minor (minor for them in terms of traffic) locations worldwide (telecom circuits between computerised nodes were shared). SABRE operated by American Airlines was the first GDS; terminals were installed in travel agent offices and it was possible to make reservations not only for American Airlines flights but for a lot of other airlines having their flights recorded in SABRE computers. The system was also used for hotel reservations or to hire cars. To be dependent on American Airlines to make reservations was not satisfactory; so, other consortia were formed by airlines: GALILEO, AMADEUS … The GDS are sophisticated network and computer systems which are very expensive both to build and to operate. Today most of them are on the stock exchange even if they are still partly owned by a group of airlines. Most of the Flag/Network carriers are affiliated to a GDS. Only the “low cost” airlines, on purpose, in line with their business model, are not. 3-5 Alliances To build worldwide seamless (or at least apparently seamless) route networks covering the whole world, Flag/Network carriers have concluded alliances. When a passenger makes a reservation with any airline belonging to the alliance, it appears that she/he is going to fly with this airline. Actually, it is possible that none of the segments of the combined set of flights is operated by the airline with which she/he made the booking. These alliances are only commercial agreements; there is usually no Equity involved. © CCMP 2004 – Air Transport Case - by Daniel Haumont – Université Paris IX Dauphine All rights reserved

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The following figures are for Year 2003 (Source: IATA – International Air Transport Assn. –) The market shares are measured in PKM (Passengers X KiloMetres flown) STAR ALLIANCE: 112.6 million passengers, market share: 23.8% (July 2003) Lufthansa

Singapore Airline

US Airways

United Airlines

ANA (Japan)

Austrian

SAS (Scandinavia)

Air New-Zealand

British Midland

Air Canada

Ansett (Australia)

Mexicana

Varig (Brazil)

Lot Polish

South-African Airways

Thai Airways

ONEWORLD: 85.6 million passengers, market share 16.8% American Airlines

Qantas (Australia)

Lan Chile

British Airways

Iberia

Finnair

Aer Lingus (Ireland)

Cathay Pacific (Hong Kong)

SkyTeam: 55.8 million passengers, market share: 21.2% Air France

Aero Mexico

Aeroflot (Russia)

Alitalia

CSA (Czech)

KLM (The Netherlands)

Delta Airline (USA)

Continental Airlines (USA)

Korean Air

Northwest (USA)

Source: Airline Business, The Economist 3-6 Business Travellers and fidelity programmes The 1978 U.S Deregulation Act resulted in an increase of competition. For the Flag/Network Carriers, 15% of the passengers are Business or First Class passengers, however, they represent 43% of the revenues (Air France long-haul flights); so, keeping them is mandatory : this is the purpose of the fidelity programmes. The figures are more or less of the same magnitude on short and medium-haul flights where they are more and more in competition with “low cost” airlines. Most of the Business Travellers adhere to at least one fidelity programme. Flying with an airline of an Alliance, resting in a hotel member of the programme, hiring a car from a member of the programme provide travellers with bonus (Miles) which can be used for free flights once enough Miles have been accumulated. At the end of 2002, the cumulated free miles are worth $500 billion (35% of the French GDP). Hopefully for the airlines, only 30% of these miles are used; however, this represents 10% of American Airlines payload and 3% for Air France. Nowadays, the companies tend to keep the miles of their business travellers staff for themselves; this was not the case in the past.

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4- Airline COSTS: 4-1 Wages The wages represent about 30% of the costs incurred by a network airline (28.4% for British Airways in 2003, 38% for US Southwest “low cost”); it can reach almost 50% for certain airlines (i.e. United Airlines); in certain countries (USA), the pension obligations must be taken into account. Wages are only 12% for Ryanair. 4-2 Aircraft Maintenance The maintenance is usually the second higher cost (after the crew) for an aircraft. Technician and workers are paid from $40 to $60 per hour. This represents about 12% of the operating cost for an aircraft less than 10 years old. (Source L’Expansion, Feb. 2004). The maintenance cost, when it is performed by a Network airline for its own aircrafts, is 30 to 50% higher than when it is subcontracted. 4-3 Airports Airports are operated by different authorities; it is variable according to the countries. Since operating an airport has a cost, it has to be incurred by the airlines and their passengers. Large Hub airports have a higher operational cost and they charge the airlines accordingly. The “low cost” airlines, partly to avoid this cost, fly from secondary airports which are usually located further from downtown. In addition, in these airports the turnaround time can be minimised. A pure player like Ryanair sticks to the “low cost” model but easyJet obtained slots in large airports. 4-4 Cost of Fuel and Oil The cost of oil varies a lot, depending on political decisions of a few countries, most of them part of a cartel named OPEC controlling 46.7% of the production in 2002. The airlines in order to protect themselves use financial instruments (fuel hedge) to balance, to the possible extent, their cost of fuel over a period of time. These are pure financial decisions taken by the airlines and in a certain sense, bets (Ryanair was 100% covered in 2001, easyJet 0%, British Airways, Lufthansa, Air France 50%). According to Morgan Stanley, in 2001, the fuel represented from 8 to 13% of the operating expenses of a Flag/Network carrier and between 15 and 23% of those of a “low cost” airline. A recent fleet is an important parameter to save on fuel. In this respect, Singapore Airlines is a model and TWA the opposite; of course, to operate new aircrafts an airline has to be able to afford them. The average yearly price of the barrel of crude oil was $10 in 1970; from 1973 to 1978, it was worth $20, then in 1981 it reached $50. Later on, it went up and down over years to be back around $20 from 1985 to 1991. A more chaotic period followed with a price varying between $10 and $20. In the first Quarter of 2003, under a specific political situation, it was over $30 and it is still over $30 in 2004.

With such variations, it is clear that for airlines with already limited margins it is difficult to maintain a profit over the years. 4-5 Air Traffic Control (ATC) In the US the ATC is unified; in Europe, there are almost as many ATC systems as there are countries. En route charges represent 9% of the total operating expenses for Ryanair for instance (this corresponds to two thirds of the fuel charges, already quite high). A much simplified system would be technically suitable and economically justified. Air traffic controllers are a very unionised population. Multiple systems can conduct to misunderstandings; this is what happened with the crash of a Tupolev in 2002 near Koblenz on the German-Swiss border. © CCMP 2004 – Air Transport Case - by Daniel Haumont – Université Paris IX Dauphine All rights reserved

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4-6 Catering The meals for the passengers are provided by airline subsidiaries (Servair for Air France) or specialized firms (Marriott) 4-7 Flight planning and Meteo. Each flight has to be planned in order to take into account winds at different altitudes as well as any other meteorological information (storms …). 4-8 Ground Handling These are the costs incurred by an airline for the locations where they fly. They can be subcontracted to specialized airport companies like Penauille (i.e. Lufthansa abroad). 4-9 Insurance With the growing risks incurred by the airlines, insurance premium have increased a lot recently.

5- The aircrafts: present and future There are different ways to have an aircraft: either it is bought by the airline or leased from specialized financial companies (the leasers). The main leasers are: GECAS (General Electric), Boeing Capital, ILFC. Airbus has steered clear of leasing. There are different forms of lease: financial lease (similar to the real possession of the aircraft which is depreciated by the airline), operating lease (rental), wet lease (including crew, maintenance and insurance). The prices of an aircraft vary a lot according to the number of aircrafts in the contract; in 2002 Ryanair and easyJet made deals with Airbus and Boeing for 100 new aircrafts to be delivered over a 10 year period. Usually, the contracts have a clause authorizing the buyer to cancel some aircrafts or to delay the delivery. Obviously, these amendments to the contracts have a cost to be incurred by the buyer. Prices can be revised depending on the delivery time and according to the variations of the world economy. The discounts are usually around 8 and 10%; sometimes, they can reach 20%. The launching company for a new aircraft gets some savings. The Jetliners from Boeing and Airbus are priced between $50 million (B737, A320) and $150 million (B747), up to $250 million (A380); they should fly (block time) 9 hours a day for A320 and 16 hours a day for a B747 to be economically suitable. The loan or lease payments have to be paid even if the airplane if kept on the tarmac. The low cost airlines which need less than 30 minutes between a landing and the next take off are optimizing the number of hours flown. The engines for a plane are acquired separately: the same B737 can be equipped with General Electric engines, Pratt and Whitney ones or Rolls-Royce ones. The engines are worth between 20% and 25% of the total price of a plane (about $6 million per unit); one spare engine per 4 engines is needed. The following figures are based on a fictive 750 aircrafts new programme: (Source: France Aviation, March 1990): The R and D for a new aircraft represents 4 years of work : 35% for the studies and the definition of the new plane, 50% for the prototypes and engineering tools (the prototyping process is highly improved by softwares like CATIA from Dassault System; Boeing uses CATIA) and 15% for the experimental flights. This requires that 70 planes are sold to be compensated. During the production phase, a lot of modifications are carried out to take into account technical evolutions, customers requests, the reaction of the competition; this part is worth 40 aircrafts. So a total of 110 aircrafts should be sold to fully depreciate the R and D related to the development of a new plane The R and D cost is increasing with the more recent and future aircrafts.

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The future A380, the largest jet to start flying in 2006, is not a revolution even if it offers a substantial increase in comfort. It will allow a 15 to 20% cost reduction per seat available, and this is a key success factor when competing against the B747 for a sale. The breakeven point is usually reached after 10 years of operation, in other terms 14 years after the programme has been launched and 580 aircrafts have been sold. Before a new aircraft programme is launched, Boeing and Airbus must be sure that enough units will be sold to avoid an economical fiasco. This is the aim of the presales. Airbus has, in 2003, 85 firm orders for its 555-passengers A380 to be delivered from 2006. The programme was launched in Year 2000 . Its development cost reaches $11 billion according to Airbus. Boeing says it should be between $14 and $20 billion. The Boeing Sonic Cruiser programme (250-passenger near-supersonic airliner which would save one hour off 3000-mile flights) was abandoned and the 7E7 “Dream Liner” was “pre- launched” at the end of 2003, but it is still awaiting a final green light; Boeing is in search of enough potential customers. Boeing and Airbus have both in 2003 a 50% market share of the “more than 100-passengers aircrafts” segment. The main competitors for the smaller aircrafts (less than 100 seats) dedicated to commuters and regional airlines are Embraer (Brazil), Bombardier (Canada); BAE (UK), ATR (Europe/EADSItalian/Alenia consortium), Fairchild Dornier (German). Russia (Sukhoi) and China are also planning to develop regional airliners. Airbus with the A318 and Boeing with smaller variations of the B737 are entering this market. What might be a real innovation in aircraft design? - A radical new plane? The blended wing? (Source: Business Week, November 25, 2002) Boeing inherited the concept from McDonnell Douglas research in 1997 when it acquired this company which was number 3 for the commercial planes. It is an aircraft with no visible fuselage and 2 large wings all along the fuselage; it is an aircraft without a tail The shape of the aircraft resembles a triangle. There would be very few windows due to the shape and this is considered as a commercial weakness . With such a radical design, it is a cultural shift in engineering. 50 years ago when Boeing decided to shift from propeller aircrafts to Jetliners, it took a risk. The legendary company’s chief engineer, Edward C. Wells helped settling the issue when he said: “life is too short to spend it working on propellers”. This was a quantum leap. Today Boeing seems more conservative. The blended-wing concept was originally developed by Jack Northrop in 1940 and the concept is still flying as the B2 Stealth Bomber. The blended-wing aircraft has far less downward drag than today’s jets. The planes might be large (450 seats) or small (250 seats); manufacturing costs might be 25% lower than conventional aircrafts with the same size. It would consume 32% less fuel per seat. It would be at full load 18% lighter than conventional jets. It would fit in the current airport loading systems. And could be built in present Boeing plants. Launch cost would be more than $10 billion, but the plane would have military versions, the Pentagon might support the project. - Unmanned Aerial Vehicle (UAV) in the military jargon: No pilot in an aircraft.

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Northrop Grumman has successfully tested from the US to Australia a quasi “normal” aircraft (Global Hawk) without a cockpit: a pilotless flight. It is a step further than auto-pilot already commonly used. Today only takeoff is not yet automated on civil aircrafts. “Passengers could be routinely travelling in pilotless planes by 2030. The big challenge is not the technology but convincing the public to get on board” (Source: The Economist, December 20, 2002). It might work for freight planes before, a company like Federal Express would save a lot of money with pilotless planes. 6- The alternatives to flying with a Scheduled Airline Who are the passengers? There are 2 main categories of passengers: leisure passengers and business travellers; their expectations from an airline are not the same. One big difference is the leisure passengers pay their tickets themselves, but business passengers have their tickets usually paid by their companies. The word “Leisure” qualifies “cost conscious” travellers. In all industries, companies become more “cost conscious”. Where are people flying ? Long haul flights (transoceanic and transcontinental flights) and short haul flights are not flown with the same planes. There are leisure locations almost everywhere as well as for business locations. Short haul flights can be in competition with high speed trains, and even with standard trains and cars. The substitution is possible to variable extents depending on the countries (in the USA since the passenger trains are not efficient, the plane remains the major domestic transportation system for individuals). If for leisure one has to go somewhere, for the business world, there are different means to meet people. Teleconferencing is a way to meet and discuss with remote colleagues, suppliers or customers. In this respect, the telecommunications facilities available now make easy such virtual meetings; however, this does not replace face to face meetings. Alternatives to flying a commercial airline ? For business executives, the Corporate jet option is becoming more attractive when the time required to check-in is increasing due to security measures. Corporate jets may take 10% of first-class travellers by 2005 (Source: McKinsey Quarterly). Corporate jets can be used on a timeshare basis: NetJets (USA) allows thrifty executives to fly on short notice. The CHARTER airlines and the Tour Operators (T.O) The Charter airlines differ from the scheduled airlines in the sense they do not usually sell their seats to the passengers or the company the passenger is working for, but they sell them to Tour Operators which buy “by quantities” (allotments) at negotiated prices. The presales are made a long time before the flight departure (For Year 2004 at the end of Year 2002). In France, 10 million passengers travel by charter each year. AERIS, a French independent charter airlines, with 700 000 passengers per year, was the third French airline, but it went bankrupt in year 2003 when it managed to be an airline with schedules. The passenger does not know which charter airline she/he is going to fly. Many Tour Operators own charter airlines (T.U.I. - Germany - formerly Preussag), owns 6 airlines: Hapag-Lloyd, Britannia, Scandinavia, White Eagle Airlines, Neos and Corsair through its acquisition of Nouvelles Frontières. Look Voyages owns 44% of Star Airlines. © CCMP 2004 – Air Transport Case - by Daniel Haumont – Université Paris IX Dauphine All rights reserved

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Some Charter airlines, which by definition have low costs, are interested in having also a “low cost” airline business unit. My Travel as a Charter operates with 49 planes and 70 destinations from 21 UK airports; in year 2002, My Travel launched an experimental regular service with 2 Airbus A320 flying between UK and Switzerland. 7- The distribution system: The role of travel agents Airlines are selling SEATS for a flight operated at a certain date/time. Most of the seats are sold through an intermediate stage: the seat RESERVATION. A reservation can be made without buying the ticket immediately. On some destinations, there is a shuttle system which does not require preliminary bookings. Reservations can be made on several flights from different airlines at once (this is possible thanks to the interconnection facilities offered by the airlines). However, the “low cost” airlines, on purpose, do not provide interconnection; this is in line with their business model. The distribution channel is a high cost for the airlines which are managing to lower their distribution cost. The distribution cost for major airlines represents the third category (18 to 25%) of expenses after the wages. Some of the seats are sold directly by the airline. However, most of the seats are sold by retailers (travel agents) and a commission has to be paid to these retailers (presently between 4 and 7%). Commissions represent 50% of the cost of distributing. The trend, as regards the commissions, is to have them suppressed and replaced by premiums and by “fixed commissions” paid “per transaction” by the airlines. In Europe, the situation is quite variable according to the countries. In these negotiations, the most powerful player is the airline. The rest is essentially paid as fees to the Global Distribution System actors – Sabre, Galileo, Amadeus, Worldspan - (the GDS terminals are used by the travel agents to make reservations): for a passenger reservation, the cost incurred by an airline is from $11 to $14 per round trip to process a full reservation transaction by the GDS; $3 for a single segment It is a substantial part of the distribution cost. This overall cost of distribution in the aviation industry is one of the highest in the service industries. On the other hand, Internet now impacts the industry; Expedia Inc., an on-line travel agency, is one of the most successful web business, dictating terms and prices to airlines and hotel chains. Expedia and its competitors scare the travel industry: online travel, corporate travel, hotels, airlines, global distribution (GDS). Some airlines launched their own web travel business: Orbitz.com. American Express competes mainly for business travellers (85% of major Corporate accounts in the US). However, Expedia, Travelocity (created by the GDS SABRE, a subsidiary of AMR - American Airline Group), Priceline.com are picking market shares in this segment. OPODO is both an Internet portal and a travel agent; it was formed in 2001 by the major European airlines : Air France, British Airways, Lufthansa, Alitalia, KLM, Iberia, Finnair, Austrian airlines and Aer Lingus. Its ambition is to offer the best tariffs (25% less than the present travel agents) on 480 airlines and in 54,000 hotels. The “low cost” airlines escape the system by selling their seats directly to the passenger through telecommunications facilities: phone and Internet. 86% of easyJet reservations are made through Internet, 70% for Ryanair. Tickets are less and less printed out and handed over to the passengers, this for saving purpose; an alphanumeric code, sometimes named record locator, is provided to the future flying passenger; the code is worth the reservation and the payment. This code is used for reconciliation purpose at the airport check-in process. The “low cost” airlines are only operating this way.

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8- The two main business models 8-1 The Flag/Network Carriers (Majors) The first Flag/Network carriers went into operation 70 years ago. Later on, in the 60’s, any new independent country wanted its Flag to be shown on aircrafts. Large countries had, in addition to their Flag/Network carriers, very often owned by the State, some private airlines. In France, in addition to Air France, there was Air Inter for the domestic flights and UTA for international flights. In 1989, the two companies were absorbed by Air France. In USA, there were two distinct markets until 1978: International airlines (PanAm, TWA …) and mainly domestic airlines (United Airlines, American Airlines, Delta, Continental …); most domestic airlines became international after the 1978 Deregulation. Usually, for a given city pair, there were only 2 airlines operating; they agreed on a common price and shared the profit of the line; tickets were transferable and the IATA (International Air Transport Association) clearing house attributed the money to the right account (like banks with checks). Most of these airlines are highly unionized; when the market was growing without real competition thanks to an industry organization which was controlling the rights to operate, it was possible to pay good salaries to the personnel and high salaries to the pilots. Today, the unions do not accept lower salaries unless the situation is catastrophic – bankrupt - (American Airlines has negotiated in 2003 a wage reduction of $1.8 billion for its 16,200 mechanics and 13,500 pilots; this reduction represents 25% of the total salaries). Even when the staff owns the majority of the shares (55% for United Airlines since the ’80s when an ESOP took place in a distress situation), they accept a cost reduction only when this is the only issue to survive. The US took control of the American railway system 20 years ago. Will it be necessary to do the same for the US airlines? It is not impossible; the airlines have been already substantially subsidized since the events of September, 11, 2001. The issue is: can they otherwise survive by themselves? The situation is less dramatic in Western Europe where a few companies were still making profit in 2002 (Lufthansa, Air France); it will hardly be the case in 2003. The AEA (Association of European Airlines) is lobbying so that subsidization of European airlines is authorised by the EU Commission). Lufthansa is offering luxury 48 seat B737 and A319 aircrafts on the North Atlantic to attract Business Executives. The working hours of most big airlines staff are about 30% less than for the new airlines (44 hours per month for United versus 62 hours for the “low cost” Southwest); the productivity is in line with the working rules, as well as the cost of human resources which represents roughly 30% of the overall operating cost. Aircraft utilization is measured in block-hours per day (hours an aircraft spends in the air). Aircraft productivity in ASM per day (Available Seat Miles) = Number of departures X average stage length X Number of seats: “In domestic USA, Southwest Aircraft productivity per day is 37% to 51% higher than United Airlines or Continental for the same type of plane” (Source MIT-ICAT). Aircraft seats and utilization explain half of JetBlue 13% to 21% cost advantage vs Major US airlines. In the US, 50% of the costs are related to aircraft operating; this includes wages, maintenance as well as aircraft configuration and utilization and 50% are related to servicing, sales/reservation, system costs. The Hubs are costly to operate; the big airlines are trying to change that by spreading out the flow of passengers throughout the day but it is difficult. According to IATA (International Air Transport Association), the airlines losses amount to $30 billion over the years 2001 and 2002. The Web has made easy to compare prices, so more passengers are paying lower fares. © CCMP 2004 – Air Transport Case - by Daniel Haumont – Université Paris IX Dauphine All rights reserved

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Most of the carriers operating hub-and-spoke airports do believe that their product will attract “rich” paying passengers (Business class, Frequent flyer programmes); American Airlines estimates it can sustain a 30% revenue premium on its “low cost” competitors; is it realistic ? The issue is: is it possible that the so called Flag/Network carriers operate with enough profitability in the coming years or are they facing a situation similar to the one of the steel industry 20 years ago? 8-2 The “low cost” airlines The inventors of the “low cost” concept consider “extra passengers are coming from a new demand created by rock-bottom prices” (Ryanair, Mr Koehler). Price elasticity is the driver of the concept; therefore, the inventors of the “low cost” are targeting new travellers, not wealthy enough to afford to fly with the big airlines. Thus, in order to offer low fares, an airline must have low costs. Some airlines managed to be low fares without the capability to be low costs (Air Lib Express in France for instance). The first “low cost” were created in the USA in 1970 (before the Deregulation Act of 1978). Southwest and People were the first “low cost” airlines; People which was considered as a model in the early 1980’s went bankrupt. Southwest is highly successful and was profitable in 2002. The second wave took place on the UK market around 1995 after the European deregulation; Ryanair (Ireland) and easyJet (UK) were the first players. The market share growth of the “low cost” airlines on the European market is 7% per year in terms of number of passengers (Goldman Sachs Research Report, June 2002). Regarding the future, the figures from the different sources vary a lot; it might reach 30% (CSFB Research Report, June 2002). In the 21st century new regional areas have their “low cost”: Eastern Europe, Australia, Asia, Latin America. The basics of “low cost” are : •

Operate short haul or medium haul flights (less than 4 hours)

•

No interconnection with other airlines (a passenger has to manage himself a transfer onto a connecting flight with another airline)

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The flights are not referenced in the Global Distribution Systems

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Low distribution cost: use of Internet instead of working with travel agents

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One type of aircraft (usually B737)

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Polyvalent staff and normal wages, however with more working hours

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Use of secondary airports and quick turnaround (time spent by the plane at the airport)

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Extensive use of the planes (2400 hours/year per aircraft for Air France, 3200 hours/year for a low cost)

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No frills for the passengers: no free drink, no newspapers

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Charge everything to the passenger : use of the call centre, payment by credit card, change of the reservation when possible…

All the so called “low cost” do not apply to the same extent all the principles referred to above. Ryanair is among the major “low costs” the one which is the more in accordance with “the low cost rules”. easyJet which operates also from Paris-Orly pays higher fees to the airport and has less flexibility in managing its schedules than in a smaller airport. 8.3 The competitors Since these airlines only operate short haul or medium haul flights, the competition is limited to the airlines operating in the same regional area. © CCMP 2004 – Air Transport Case - by Daniel Haumont – Université Paris IX Dauphine All rights reserved

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It is based on direct flights with usually a higher frequency than major airlines; the Hub concept for “low cost” airlines was not effective at the beginning in Europe. In 2002, Ryanair created for itself a Hub in Charleroi (near Brussels) allowing Ryanair passengers to fly several consecutive Ryanair flight segments. It has now two additional Hubs in Frankfurt-Hahn and Milan-Bergamo. North America: The North American market is the most mature one; however, this maturity has to be scrutinized into more details. Southwest was launched in 1971; it was imitated by very few competitors until the end of the century. The deregulation of 1978 impacted the existing big airlines of that time which lowered their prices; some of them went bankrupt (PanAm, Braniff, Eastern Airlines …); a consolidation took place and subsequently the prices increased. This was a new opportunity for the entry of “low cost” airlines on the US market. JetBlue, launched in Year 2000, is the most remarkable success. It leads the domestic traffic from Kennedy airport in New-York (JFK is mainly an international airport). JetBlue operates 32 Airbus A320 (75 targeted in 2005). JetBlue is not a pure no-frills player; it offers a mix quality-price with new aircrafts, seat allocation and satellite TV for each seat; each seat is a leather seat (easier to maintain). Distances which are covered can be larger than in Europe (New-York Long-Beach/Los Angeles). JetBlue is profitable even in years 2001 and 2002. AirTran (former name: ValueJet) was originally operating used B737 aircrafts; it is now operating smaller new Boeing B717. All together, US no-frills operators have captured a 20% share in terms of passengers in domestic air travel, and a 15% share in revenue. Even for competitors like Delta Airlines (third US airline) “the discounter’s national market share will double to 40% in the near future” - Delta President Reid (Business Week, October 28, 2002) -. The US Majors are creating “low cost” subsidiaries; will they be able to follow the pattern ? SONG (from Delta Airlines) and TED (from United Airlines) went in operation in 2003; American Airlines is still dubitative. The examples of British Airways GO and KLM BUZZ, acquired by real “low costs” create some doubts. US Business travellers are rapidly changing their habits moving to “low cost” airlines. In May 2003, Southwest was the first US airline as regards the number of domestic passengers.. Western Europe: Until the European deregulation act, it was very difficult to launch a new airline due to the lobbying of the Flag/Network Carriers highly supported by their Governments. Most of the new entrants failed. From 1995, European no-frills operators have captured a 7.5% share in terms of passengers. In the UK, the market share is 22% McKinsey doubts that Europe’s no-frills can do as well as the American “low cost” airlines due to the structure of the European market. The strength of the incumbent airlines as well as established packaged-tour operators play an important role. Ryanair was born in Ireland in 1985 as a standard airline; for years, it was not successful with its strategy and finally was on the verge of bankruptcy when a new CEO, Michael O’Leary took the head of the company with a new strategy: to be a no-frills airline. easyJet was born in 1995 in UK with, from its early stage, a clear no-frill strategy. It operates now from 3 airports in London further to its acquisition of GO from British Airways. The Flag/Network carriers in the UK and the Netherlands launched their own “low cost”; they were handicapped by their parent companies costs, British Airway (BA) and KLM. Thus, GO for BA and BUZZ for KLM were not, due to their actual operating costs, in a position to be as cost effective as the pure players. In 2002, GO, as well as Deutsche BA (not yet finalized) were sold by BA (GO was sold

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to 3i before) to easyJet. GO was paid €600 million. Ryanair acquired BUZZ which they paid less than the value of a unique B737. Virgin Express (UK/Belgium) is not a pure “low cost” and, in this respect, is less cost effective than the pure players. Air Berlin on the German market, Germanwings from parent Lufthansa, Hapag-Lloyd Express from the German Tour Operator TUI are taking off. Several other launchings are prepared in Western Europe. In Italy, Volare is operating from Italia to Western Europe and has made an alliance with Hapag-Lloyd (TUI Group). Many “low cost” airlines are taking off in Eastern Europe: SkyEurope (Slovakia, Hungary), Wizz Air (Poland, Hungary), AirBaltic (Latvia), CSA low cost (Czech), JAT low cost (Serbia), NL Luftfahrt (Austria). To be a “low cost” does not prevent such an airline to use Yield management as regards tariffs… and it is very efficiently used. Rest of the world There is a handful of upstarts Asian carriers mostly on domestic routes: Bangkok Airways (not really a low cost), PB Air and Air Andaman (Thailand), Cebu Pacific Airways (not sticking 100% to the “low cost” concept - Philippines), Air Asia (Malaysia), Siem Reap Air (Cambodia). In Brazil, where the air transport is expensive, two “low cost” are now operating: Gol and Fly. In Australia, Richard Branson (Virgin) launched a new “low cost”: Blue. To be “low cost” does not prevent an airline to go bankrupt despite of the demand growth for this type of transport. The list of the failing “low cost” grows: Vanguard (US), Air Lib Express (France), Goodjet (Sweden), DragonAir (UK) are some of the failed “low cost” which went bankrupt; others failed (Buzz, Go) in implementing their strategy but they were acquired by stronger ones. A special case: CONCORDE The CONCORDE segment between Europe and America, now disappeared, has been a niche segment. The travellers were both Business Executives, wealthy leisure people or rich artists ready to pay $45 for each minute in the sky. It had been a strategic segment by itself for British Airways and Air France, with a unique key success factor: its supersonic speed … but at what cost!

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Conclusion This industry is very specific with poor returns. Since the very end of the twentieth century a new category of players have entered the market with a new business model: the “low cost”. Southwest created in 1971 is a model and a special “old” successful case; People Express was at that time based on the same model but they went bankrupt when they attacked American Airline on their routes. “The airline business is an aberration. Distorted by decades of subsidies and international cartels, it has never earned a real rate on return on its investor’s capital in its 60 years of existence …” The Economist, Special report Airlines, Oct. 3, 2003 Is lack of competition due to over protection by the Governments the problem ? Is an “Open Sky” Agreement on the North Atlantic area, between US and EU, part of the solution? The EU have calculated that such an open area across the Atlantic could benefit consumers of €5 billion ($5.8 billion in 2004) a year and help airlines by stimulating traffic and facilitating consolidation. Is IATA (International Air Transport Association) a cartel much stronger than OPEC despite of 1978 US deregulation and later on, in 1993, EU deregulation ?

Questions 1. Strategic segmenting of the passenger air transport industry 2. Value chain of an airline. What parts of the value chain the Majors should focus on? What parts might be outsourced? 3. How can the Majors react in Europe in order : a. To increase their market share on the Business segment; are they threatened by the low cost airlines on this segment?

b. To save their market share on the segment « Mass market / Leisure » 4. Does the “low cost” airlines Business Model work for long-haul flights ? 5. Will consolidation in Europe with transnational mergers be an improvement (i.e. Air France, Deutsch KLM) ? 6. When operating costs are so high for so many airlines, is there a way for a profitable competition ?

7. Is a Diversification strategy an opportunity for the airlines ? This concerns the Majors as well as the “low cost”. 8. One thing is sure, the Airline industry will not disappear. So what ? How do you see a profitable future? (Profitable not only for the low cost airlines)

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Internet sites http://web.mit.edu/urban_or_book/www/animated-eg/ym/ (A business game about Yield Management) http://web.mit.edu/airlines/faculty.html (Massachusetts Institute of Technology - MIT) http://www47.americanexpress.com/corporateservices/newsroom/press/press_11.asp (about business fares and leisure fares policies in the USA) http://www.aerolink.com (the Internet’s commercial aviation directory) http://www.ryanair.com/investor/results/2003annualreport.pdf (Ryanair 2003 financial results) http://media.corporate-ir.net/media_files/irol/69/69499/ar2003_Final.pdf (British Airways financial 2002-2003 annual Report) http://www.southwest.com/about_swa/financials/investor_relations_index.html (Southwest financial) http://biz.yahoo.com/ic/airlin.html (Yahoo about Airlines) http://www.atwonline.com/ (Air Transport World – US Review about airlines) http://www.iht.com/articles/509936.htm (Business jets soar in the wake of Concorde)

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