While there is a logic in the BA approach of moving towards a virtual airline in terms of reducing costs through outsourcing, it does carry a major risk. The airline business is very cyclical. Concentrating purely on the core activities and abandoning the provision of peripheral services makes an airline more susceptible to any sustained economic downturn. If passenger growth falls off or if yields decline and revenues go down there are no countervailing sources of revenue, from, say, catering or ground handling services, to offset the revenue fall. Revenues from these areas may also be adversely affected by a cyclical downturn, but much less so than the core airline revenues. After all, other airlines’ aircraft, as well as one’s own, still have to be handled or maintained, and passengers continue to require in-flight meals and catering. In 1999 it was the absence of any countervailing revenues from other sources that led to the dramatic drop in BA’s profits. This poor performance and the collapsing share price ultimately lead to the resignation of the chief executive, Robert Ayling, in March 2000, one of the chief proponents of the virtual airline strategy. Airlines such as Lufthansa or Swissair also saw profits from their airline business decline that year. Like BA they too were affected by higher fuel prices, overcapacity in key markets and falling yields. But revenue in their ancillary businesses held up better and helped cushion the shortfall in airline revenues. Their chief executives did not have to resign!
The Lufthansa-Swissair paradigm also involves some risks. If, as seems most likely, the core airline business is required to buy all the services it needs, such as catering or maintenance, from its own non-core business units, can one be certain that it is always obtaining the best and cheapest deal possible? On the other hand it could be argued that because these specialist business units are likely to be large they will enjoy economies of scale, and since they are constantly in competitive bidding for external third-party work they are likely to be more efficient than an airline’s internal supplier who does not face real competition. There is an added risk that, in the longer term, the non-core businesses may prove consistently profitable while the airline business itself is marginal. Does one then abandon or sell off the latter and keep the former?
In the coming years airlines will have three business models to choose from. There is the traditional model of the self-sufficient airline which provides in-house most of the necessary ancillary support services. This may be more expensive than contracting out but the management feels it is in control of its destiny. Some contracting out is undertaken but usually in specialist areas or for services away from its home base(s). Work may also be contracted in from other airlines. Such work is always welcome but not seen as a major revenue source in its own right, rather as a way of optimising the utilisation of existing staff and facilities. Second, there is the virtual airline model partially adopted by British Airways. But perhaps the best examples are some of the European low-cost carriers such as easyJet. Cost minimisation is the priority. If any service or function can be provided more cheaply by an external supplier then it should be outsourced. This is of course much easier to do for new start-up airlines than for airlines trying to move from the traditional self-sufficiency model to a more virtual model, since they are encumbered with existing staff and facilities. They inevitably face considerable employee and union opposition. Finally, there is the aviation business model. This sees each of the ancillary activities related to the core provision of air services as separate and potentially profitable businesses in their own right. Moreover, such businesses aim to capture a customer base which is much larger and wider than their own host airline. To date, the most successful proponents of this model are Lufthansa and Swissair and to some extent Singapore Airlines. Surprisingly, no North American airlines have yet gone down this road.
Airline executives and their boards will have to choose which of three business models to adopt and develop as part of their long-term corporate strategy. A priori, the third option, the aviation business model, appears to be the most attractive. However, not all airlines are large enough or have sufficient resources to adopt this model.
Developing an alliance strategy
There are strong economic forces driving the airline industry towards increased concentration and globalisation. In turn it is the existing regulatory regime which has forced such concentration to be achieved through alliances of various kinds rather than through cross-border acquisitions and mergers. The alliance frenzy will continue. New partnerships will be forged and some old ones will break up. For all airline executives, but especially those of medium-sized and smaller airlines, this is a major area of uncertainty and concern. They understand the clear rationale in favour of alliances, but also perceive that alliances pose a real threat, especially as they evolve from being largely commercial to being more strategic and binding. Many are worried that by entering into an alliance with a larger carrier or group of carriers they will lose effective control over their own destiny in matters such as route development, pricing, branding, customer service standards, and so on. They fear that decisions will be made by the two or three dominant carriers and that junior partners will have to follow along. There is also great concern as to how airlines should choose between possible partners when alternative alliances are available. To overcome such concerns airlines need to develop a clear and coherent alliance strategy.
The economic pressures pushing the airlines into alliances are real since the benefits from joining alliances can be very substantial. This is particularly so in terms of the marketing advantages of larger scale and scope. This, however, does not mean that alliances are an end in themselves. They should only be seen as a means to an end, which is to improve an airline’s operating and marketing efficiency and its financial returns. This means that each alliance proposal should be examined on its merits. Some, perhaps many, may need to be rejected after careful evaluation. Evaluating and developing alliance tactics and strategy requires three clear steps.
The first is for an airline to identify and clarify its own objectives and aims in seeking a particular alliance with another carrier or group of airlines. Is the focus in increasing market spread through serving more destinations? In other words is it on revenue generation? Or is the initial focus on reducing costs in particular markets or individual routes through a joint sales force, shared sales offices, mutual ground handling, and so on? In many cases both revenue generation and cost reduction will be primary objectives. But to what extent is the avoidance or reduction in competition between the prospective partners an objective? In some cases, especially on route-specific alliances, this may be the primary aim with cost reduction taking second place. For those airlines seeking a strategic investor, as part of a privatisation process, the need to attract and inject new capital may be the most important consideration in choosing an alliance partner. One needs not only to identify the objectives to be achieved in entering partnership but also to prioritise them.
The second step is to determine what kind of alliance best meets the objectives identified. If the objectives relate primarily to a particular route then the airline will most likely wish to enter a route-specific alliance. It could, as many airlines do, have separate alliances involving code-share or other agreements, for different routes on its network. A smaller airline with a domestic or regional network may feel that its objectives can best be met by entering into a regional alliance with a larger carrier. This would involve linking a significant part or even its whole network into the larger partner’s route system. This could be done through simple code sharing on several routes and joint marketing and possibly joint selling. Or, at the other end of the spectrum, the smaller carrier could operate as a franchisee of its larger partners, adopting its livery, brand and service standards. The latter would be a truly strategic alliance. Alternatively, an airline might feel that its longer-term objectives could best be satisfied by joining a truly global world-wide alliance. This would be the case if it gave priority to achieving the widest network spread possible. If it decides to follow this strategy, then there is a further choice to be made. Should it join a global alliance that is marketing oriented such as Oneworld, or should it seek a more strategic alliance such as the Swissair-Sabena grouping which is likely to involve greater co-mingling of assets.
The final step in developing an alliance strategy is to assess and quantify the benefits and costs of different potential partners. Many related issues need to be considered and, where possible, quantified. The starting point should be to ensure that, a priori, there are potential benefits to all partners and that such benefits are broadly in balance. If one partner feels it is getting much less out of the alliance than the other partner(s), then the alliance is inherently unstable. To assess both the balance of benefits and an individual airline’s advantages in moving into a partnership, a very detailed route-by-route assessment is required. This will forecast the traffic gains, in terms of additional passengers or cargo, as a result of the link-up with the other carrier, and the marketing improvements which are created. Traffic and revenue gains may also result from reduced competition on routes where the alliance partners were previously competing head on. These traffic gains will need to be converted into increased revenue projections. Any increased operating costs resulting from higher traffic levels would need to be offset against the revenue improvements. It would also be crucial to assess any revenue reductions on routes not directly part of the alliance agreement if the latter leads to a redirection of passengers to a new hub. For instance, Aer Lingus’s decision early in 2000 to join the Oneworld alliance may mean that Aer Lingus passengers previously hubbing through Amsterdam to fly long-haul destinations would be switched to London to transfer onto British Airways. Aer Lingus revenue from a Dublin-London passenger transferring in London would almost certainly be less than from a Dublin-Amsterdam passenger doing the same in Amsterdam. On the cost side, the level of cost reduction through joint activities and synergies of any kind will very much depend on the nature of the agreement between the partners. An alliance may of course result in some increased costs from a variety of sources such as the need to advertise the alliance or from some rebranding and service improvements. All the potential benefits and costs arising from alternative partnerships must be evaluated in detail. In turn these will reflect the degree to to which a partner’s network is complementary in scope and destinations served rather than one which merely duplicates one’s own network. In traffic generation terms the former is likely to be more attractive. For smaller airlines linking with a larger carrier, the attractiveness and efficiency of the latter’s hub(s) is an important consideration. But this too should be reflected in the amount of new traffic generated.
There are also non-quantifiable factors that need to be considered. Often they may be the most critical in choosing an alliance partner. Do the partners have a common long-term vision of where they want the alliance to go? Do they have shared objectives? A failure to share and work towards common goals will eventually destroy the alliance. This is what happened with the British Airways-US Airways alliance and also with the earliest global alliance, that between SIA, Swissair and Delta. Apart from common objectives, partners should also have a similar culture in terms of service standards and ideally similar management styles. The latter may be less critical than the former. Another important consideration, especially for smaller airlines, is whether the alliance partner demands exclusivity. That means, would the smaller carrier be excluded from making marketing or commercial agreements with other carriers, say, on routes not directly affected by the alliance? Exclusivity may be required if a smaller regional airline has a choice of hubs through which it can interline its long-haul passengers. Even large carriers joining global alliances may be concerned about exclusivity. Thus, early in 2000 Japan Airlines was still hesitating in joining the Oneworld alliance for fear of jeopardising existing bilateral agreements with non-alliance carriers (Flight International, 28 March-3 April 2000). The final issue is to examine is whether there are strings attached to the alliance agreement. Thus, when Air Mauritius entered into an alliance with Air France in 1998 it was required to use Air France for its in-flight catering, for its aircraft maintenance and other bought-in services. In some such cases the new supplier of these services may turn out to be more expensive than the airline’s former supplier. Such impacts, whether adverse or beneficial, would also have to be costed.
It is clear that each alliance proposal and potential partner would have to be accessed in detail on a case-by-case basis. The issues raised above provide a starting point for such an evaluation. But two things should be borne in mind. First, alliances are not an end in themselves. They must be used to achieve clearly defined objectives. Second, what Michael Porter stated in relation to industrial alliances in general appears equally true of airline alliances. Namely that ‘Alliances are a tool for extending or reinforcing competitive advantage, but rarely a sustainable means for creating it!’ (Porter, 1990).
Cost reduction as a long-term necessity
In the past, the airlines’ response to the cyclical downturn that occurred near the start of each decade was a determined effort to reduce costs by whatever means possible. Staff numbers were reduced, seasonal staff were not taken on, advertising and training budgets were cut, fleet renewal was delayed, a few unprofitable routes were cut, and so on. As the economic climate improved and as airline losses gave way to profits, airline managements tended to relax their vigilance. The downward pressure on unit costs lessened. Instead of falling further, unit costs in real terms tended to flatten out and in the case of some airlines they actually rose. At least until the next cyclical downturn when a new bout of cost control and, where possible, cost reduction began. Drastic cost cutting and control was seen very much as a short-term measure to face imminent crises.
Over the last ten years or so the nature of the airline industry has changed. Progressive international liberalisation has made overcapacity endemic to many markets. The disappearance of most controls on passenger fares and cargo tariffs has made both the latter more volatile. Pricing freedom wherever it is combined with overcapacity leads inevitably to downward pressure on average yields. This problem will be increasingly exacerbated by the impact of electronic commerce which will shift the balance of market power from the suppliers, the airlines, to the consumers, that is, passengers and freight shippers. Where low-cost, no-frills airlines enter new markets they too will induce further tariff cuts among conventional airlines. In markets where liberalisation has not yet caught up where there are infrastructural constraints on airline frequencies, as at slot-constrained airports, capacity may be under- rather than overprovided, and it will be possible to ensure that yields hold up. But such markets will be in a minority. The expectation is that during the present decade the overall trend in airline fares and yields in most markets will continue to be downward.
Whether the cyclical downturn evident in 1999 continues and worsens in 2000 and 2001 or not the reality is that falling real yields are certain to be a long-term phenomenon. Any short-term increases which may occur when airlines collectively try to reverse the trend are likely to be short-lived. In the circumstances attitudes to cost control must change. Cost reduction is no longer a short-term response to declining yields or falling load factors. It is a continuous and permanent requirement if airlines are to be profitable. Many airline executives are clearly already aware of this necessity. But how can airline unit costs be contained and reduced?
Improvements in aircraft technology can play a part. The further penetration of new generation jet aircraft, as older aircraft fleets are renewed, the switch from smaller to larger aircraft, where runaway capacities have been used up or where traffic has grown sufficiently to justify upsizing, and the wider use of regional jets will all help to reduce unit costs. However, the impact will not be as great as occurred for instance when wide-bodied aircraft were introduced, because more recent improvements in engine and airframe technology are not so radical. Therefore the focus of cost control strategies must be elsewhere.
The continuous battle to contain and, where possible, to reduce costs will need to be fought on three fronts. Labour represents the largest single cost item for airlines and staff costs per employee vary significantly between airlines, especially between those in different countries. For these two reasons, labour will inevitably be the first key area for cost containment. Airlines will need to contain if not reduce the unit cost of labour and at the same time improve the productivity of that labour. The second area on which to focus is that of sales, ticketing and distribution which, taken together, account for 15 to 20 per cent of most airlines’ total costs. The key to success here clearly lies in the rapid introduction of e-commerce and online sales as well as more widespread use of automation for ticketing, check-in and so on. Finally, costs can be reduced through operational and service changes. Here, conventional airlines have much to learn from their low-cost competitors. They must explore the ways in which, and the degree to which, they can emulate any of the operational or other improvements and product changes introduced by the latter so as to reduce their own costs further. In all the areas mentioned above, it is evident that costs could be reduced through outsourcing. The degree to which airlines are prepared to follow this path to lower costs may be dependent on the business model they have adopted. Whatever strategies each airline adopts the underlying requirement is clear. Cost reduction must be seen as a continuous and long-term prerequisite for financial survival.
Marketing focused on yield improvement
The airline business is dynamic and potentially unstable. The interplay of three key factors determines whether an airline is profitable or not. These are the unit costs, the unit revenues or yields, and the load factors achieved. Low yields can be compensated for by higher load factors so that total revenues generated exceed the costs. Conversely, if load factors are falling average yields need to be pushed up in order to continue generating the same total revenue as before. The long-term trend in average yields is likely to be downward because of further liberalisation and overcapacity in some markets, because of the impact of low-cost carriers and the growing commoditisation of the airline product as distribution becomes more dependent on Internet sales. One crucial response to such a trend must be to focus on cost reduction as a continuous priority. Though industry yields may be moving downwards, each individual airline must try to push up its own yields while maintaining or increasing load factors. Marketing strategies must focus on yield improvement.
This is self-evident and easy to say. The difficulty lies in effectively implementing marketing strategies which can achieve higher yields in markets which are inherently unstable. Airlines need to focus on three areas. First, they must identify the market segments they wish to target both in their passenger and cargo markets. This means clarifying the characteristics of each segment, its product requirements and the degree to which it generates profitable business for the airline. An example of the approach needed was the exercise undertaken by British Airways in the second half of 1999 in response to falling passenger yields and disappearing profits. The study identified that economy class traffic transferring through its London hubs between two short-haul routes was the most unprofitable market segment, followed by short-haul to long-haul economy transfer passengers and economy passengers on short-haul European routes. The airline decided to reduce its exposure in these market segments by reducing the seating capacity available for them. But within each of these market segments it was possible to identify sub-segments which could be targeted. At the other extreme the most profitable segments overall were the direct short-haul and long-haul point-to-point premium passengers, that is, those paying business, full economy or first-class fares. These were the markets BA decided to grow and defend. There were some traffics which were more marginal such as long-haul to long-haul economy transfer passengers, where BA’s response was to try and improve the fare mix so as to push up average yields. Different airlines will undertake the process of market segmentation in different ways. But the aim is the same, to identify the characteristics and potential profitability of the various market segments as a prerequisite for effective marketing and pricing policies. In addition to internal economic analysis, market segmentation also requires detailed and frequent market research and customer surveys to establish the wants and needs of the different market segments.
The second step is to constantly improve every aspect of the product and service offered or at least those aspects identified as being important in the market research. This applies equally to the passenger and cargo services offered. The aim of such improvements for each airline must be to try and differentiate its product from that of its competitors. This makes it easier for the airline to brand its product and counter the trend towards commoditisation which electronic commerce will accelerate. Effective branding and product differentiation should in turn make it possible to charge a premium on the prevailing market tariff and thereby push up yields. Since any product improvement can be matched within a year or two by competitors, it is important to be innovative and constantly searching for ways to upgrade the service offered on the ground or in the air. On medium- and long-haul routes it is easier to differentiate one’s product or service because passenger spend a much longer time in the aircraft. When towards the end of 1996 British Airways was the first to introduce seats that converted into fully flat beds in first class, it generated new demand for this service and diverted passengers from other airlines. It enjoyed a major competitive advantage. BA was even able on some routes to charge a premium over the normal first-class fare for a couple of years or so until competitors caught up. The airline was hoping to repeat its success in 2000 by introducing sleeper beds in business class. Some years earlier Virgin Atlantic had identified a market segment poorly served in terms of value for money. These were the passengers who paid full economy fares on long-haul sectors and travelled in the crowded and often tightly packed economy cabin with passengers who had paid much less. Virgin set up a mid-class cabin for them and provided improved in-flight services. British Airways also recently identified this market segment as being important. As from August 2000 it was introducing a separate cabin on long-haul flights for such passengers with wider seats, more leg-room, and other improvements.
On short-haul sectors differentiation is more difficult because airlines have fewer critical product features to juggle with, since journey times are so short. They tend to focus on flight frequency as a competitive tool, on check-in procedures, on seating density, on in-flight catering and so on. Product innovation is particularly difficult. Conventional scheduled airlines have been very poor at innovation on short sectors compared to the low-cost carriers. There are several areas where further improvements could be made to speed up elapsed travel times or on-board comfort and convenience. For instance, more automated check-in, or more on-board space for hand luggage and coats. Better service features may mean higher costs. So a balance must be maintained between what is desirable and what is feasible in terms of additional revenue generated through attracting more passengers, improving the traffic mix or higher yields.
The third aspect of marketing strategy must be to ensure that an airline and everyone working within it and for it is customer focused. This means not only being aware, as a result of the market research and surveys recommended earlier, of what customers require, but also making sure that their expectations are met in a way which encourages them both to become loyal repeat customers and where possible to pay a premium. The ability to achieve this is partly related to the product and service quality being offered and partly to staff attitudes and culture. From first enquiry about service availability and fares to baggage collection at the end of a flight, passengers will have around a dozen or more separate contacts with airline employees. If any one of these turns unpleasant or is unsatisfactory for the passenger it can sour his or her view of the airline. The quality of personal contacts is of key importance in a service industry. Online selling and automation will reduce the number of personal, one-to-one contacts, but will re-emphasise how important the remaining contacts are. Too many airlines still do not have a sufficiently strong service culture. This is particularly true of many state-owned airlines and a few of the older privatised airlines. Even when airlines have developed a high-quality service culture they may begin to lose it through poor and inadequate management, as happened with British Airways in the late 1990s. Thus, in the coming years, airlines must undertake massive and constant training and retraining of staff in all departments to ensure a high level of interpersonal skills and a culture of service.
The ultimate aim is to attract new customers and capture the loyalty of existing ones. Several different tools are used, apart from the quality of service provided in all areas, to ensure customer loyalty and repeat business. A key one is an airline’s frequent flyer programme (FFP). But since frequent flyers, who are often the high-yield premium passengers, tend to belong to several airlines’ FFPs the latter are becoming less significant in choice of airline. As part of a strategy both of product differentiation and being customer focused, airlines must move rapidly to customer relations management. They must use the opportunities offered by electronic commerce and informatics to develop one-to-one relations with their customers, tailoring service provision to each customer’s individual and known requirements. The airlines who will succeed at maximising the opportunities offered by electronic commerce are likely to be those that adopt and use e-commerce the quickest and in the most wholehearted way.
Too often, airline managements place too much emphasis on improving market share as an end in itself. They tend to add frequencies and reduce fares to fill the additional seats in the pursuit of higher market shares. It appears attractive as a strategy. More passengers support even higher frequencies, which in turn provide a competitive advantage and attract yet more passengers. Higher frequencies and more passengers mean lower costs per passenger. If the routes involved are from a hub, the attraction of that hub airport is reinforced. But if one is capturing higher market share primarily through more aggressive and lower tariffs, there is a real risk that average yields fall more rapidly than costs. Or that passenger load factors do not rise sufficiently to compensate for and offset the fall in yields. It is the near obsession with increasing market share that has driven and continues to drive many airlines towards the brink of disaster, especially when overall market conditions worsen.
In the more uncertain and unstable years ahead airline marketing should be refocused to give priority on increasing yield. This can be done only through a better understanding of the requirements of different market segments, through constantly improved and innovative products and services to reflect those requirements, and through the more effective use of customer relations management.
Future developments in the operating environment
The long-term prospects for transport look good. At the start of the new millenium, the decline in annual growth rates appeared to have been stemmed. Most long-term forecasts were modified downwards after the East Asian crisis of 1997-98, but they still predicted that growth rates for worldwide air traffic would average about 5 per cent over the first decade of the new millenium. But year to year, there will be fluctuations around this average figure. Despite the continuing economic problems in some European countries, and to a lesser extent in Japan, most forecasts prepared in 1998 and 1999 are optimistic. This optimism stems from the close link that has been established historically between the demand for air travel and world economic growth. The rate of growth of air traffic seems to follow closely developments in the world’s gross domestic product (GDP). Though frequently there is a time lag before air traffic responds to changes in GDP, air traffic worldwide measured in terms of scheduled passenger-kms appears to have an income elasticity of around 2. This means that in general air traffic grows about twice as fast as the annual growth in the world’s GDP. It is because economic forecasters early in 2000 were predicting medium-term growth in world GDP to average 2.5 to 3.0 per cent per annum that airline traffic is expected to grow annually at 5 per cent to 6 per cent.
Airbus Industrie, in their long-term forecasts presented in May 1999, predicted that airline traffic measured in terms of revenue passenger-kms would grow at an annual rate of 5.1 per cent in the ten years from 1999 to 2008. Growth would slow down to 4.9 per cent per annum in the decade after that. Boeing was forecasting somewhat lower annual growth of 4.7 per cent in the first decade to 2007. Both manufacturers were forecasting growth rates for the first decade of the new millennium which were close to those achieved in the 1990s. In other words, there would be no slowing down.
In the light of past trends, all air traffic forecasters, including Airbus and Boeing, expect much higher than average growth in particular markets, notably on routes to and from the East Asia and Pacific regions. Traffic growth to and from Latin America is also expected to be above the world average. On the other hand, traffic in two of the largest international markets, those of the North Atlantic or within Europe, will grow at or below the average world growth rate.
In a climate of long-term optimism but short-term uncertainty, the market environment for air transport during the first decade of the new millennium will be characterised by significant changes both in the regulatory regime and in market structures. The trend towards a very liberal ‘open skies’ international regime is unstoppable. Within Europe, the more or less total deregulation of intra-European air services that has already taken place within the European Union will increasingly spread eastwards to the former communist states. Ten states have been negotiating to adopt the ‘third package’ and the associated competition rules. They are expected to formally join the Common European Aviation Area during 2001, which already contains the fifteen member states of the European Union together with Norway and Sweden. This will create a vast single deregulated market for air transport covering most of Europe. Other states such as Switzerland or Cyprus are expected to join shortly, even before becoming full members of the European Union. Meanwhile, the removal since 1993 of any real distinctions between charters and scheduled services within the European Union will increasingly draw the two sectors closer together. New airlines will appear though will collapse or be taken over including some of the weaker, state-owned carriers. The most dramatic impact on air transport in Europe will come from the rapid growth of low-cost, no frills airlines.
In Asia and South America a number of states have already signed ‘open skies’ air services agreements with the United States while continuing to operate on the basis of traditional and more restrictive bilateral agreements with their own neighbouring states. Such an anomalous situation cannot continue for long. The emphasis in the near future will be on liberalising the economic regime between neighbouring states. This may be done on a bilateral basis, but is more likely to be implemented under the auspices of regional economic groupings such as ASEAN in South East Asia and ECOSUR in South America. In Africa the pressure to liberalise will not come from external sources but will arise from the dire financial position of most of the African state-owned airlines. Governments will liberalise both their domestic and international aviation regimes to ensure adequate air services in the event of the collapse of the state airline when government support is no longer forthcoming. In November 1999, African nations meeting in Yamoussoukro in the Ivory Coast signed an agreement aimed at achieving a single aviation market for the continent by 2002.
While liberalisation of market access will spread, another more controversial issue, namely that of airline ownership, will also need to be tackled. In one very important respect air transport is still treated quite differently from any other industry. The traditional and even the newer ‘open skies’ bilateral air services agreements require the airlines designated by each of the two states to be ‘substantially owned’ and ‘effectively controlled’ by nationals of the designating state. As other regulatory constraints on airlines’ freedom of action in international operations are removed and as other industries become more internationalised in their ownership then the pressure to remove the nationality constraint on airlines will become overwhelming. It is inevitable that, during the first few years of the third millennium, more and more states will abandon this commercial constraint either through bilateral or multilateral agreements. Airline ownership will become increasingly multinational rather than national as at present. Privatisation of hitherto government-owned airlines will facilitate this process. The airline business will become no different from any other multinational industry. The first decade of the new millennium will finally see the complete transformation of the airline industry from a protected, nationally owned industry into a true multinational business operating freely across frontiers.
This global airline business, however, will become increasingly concentrated into a handful of worldwide airline alliances. Experiences in the United States domestic market during the 1980s showed that it was not the low-cost new entrants who were most likely to survive in a competitive environment but those large airlines which were successful in exploiting the marketing benefits of large scale and spread. It was the realisation of this that led to the growing concentration of the US airline industry through takeovers and mergers. As liberalisation spread to Europe in the late 1980s European carriers began to examine how they too could achieve the marketing benefits of large scale. They began to take over their smaller domestic competitors and looked to buying minority shares in European airlines outside their own countries.
By the early 1990s the process of concentration was internationalised. It was apparent that linking together the networks of airlines in different countries to create global networks could create not only marketing benefits for all the partner airlines but also help them in reducing distribution and sales costs. Thus, in the mid- and late 1990s one saw a host of airline alliances which took a variety of forms, from those that were little more than traditional commercial agreements, to code sharing, and share swaps between airlines or even outright mergers. A complex web of interlocking alliances was built up. Though it is true that many of these alliances had little logic and minimal commercial benefit to the alliance partners.
Many of the early alliances have not survived and collapsed after a few years as one or other of the partners sought new alliances. As part of its global network strategy British Airways bought 19.9 per cent of USAir in 1993. But in June 1996 it announced a new alliance with American Airlines, one of USAir’s major domestic competitors, and was forced to sell its shareholding in USAir. Perhaps the first truly global alliance was that between Delta Airlines, Swissair and Singapore Airlines (SIA) launched in 1990 and involving a swapping of up to 5 per cent of shares between each of the partners. The share swap suggested long-term stability for this alliance. Yet seven years later the alliance suddenly collapsed when Singapore Airlines, in November 1997 unexpectedly signed a commercial agreement with Lufthansa which included code sharing and joint marketing. Then in November 1999 Delta announced it was in turn abandoning Swissair in favour of an alliance with Air France. The experience of the Delta-Swissair-SIA partners illustrates the marked instability of alliances in the second half of the 1990s as airlines jockeyed for position. Currently most alliances appear to be engagements rather than weddings. They can be broken relatively easily.
In the latter part of the 1990s alliance activity accelerated as, with a few exceptions most airline chief executives and chairmen felt alliances were a panacea that could solve many of their airlines’ problems and create new market opportunities. Governments with loss-making state-owned airlines announced that what these airlines needed to be turned round was little more than a strategic partner (i.e. another airline) who would buy 15-30 per cent of their shares from the government. In 1998 the Greek, Irish, Portuguese, Thai and Jordanian governments among others all announced that strategic alliances for their airlines was one of the two cornerstones of their strategies for saving their national airlines. The other was privatisation.
During the next few years the global pattern of the major alliances will be rationalised through withdrawal of some partners and inclusion of others. A period of great instability will occur as soon as the nationality and ownership constraints are relaxed and cross-border acquisitions and mergers become possible. New alliance groupings are likely to emerge. At the same time competitive pressures will ensure that the commercial linkages between partners will be strengthened while commercial cooperation with non-partners will gradually diminish. The airline market will increasingly be dominated by a few global alliances or megacarriers, together with their partners and franchisees. Concentration will gradually give way to consolidation. Moreover, virtually all of the major airlines will be wholly or largely privatised and multinationally owned.
Growing consolidation within the airline business through the expansion and strengthening of alliances will raise the issue of market dominance and the possible abuse of that dominance when alliances operate as monopolists or duopolists in particular international markets. The risks of abuse will be greatest when and where an alliance dominates a major airport hub.
Despite greater industry concentration there will be a strong downward trend in fare levels and airline yields in real terms. A number of factors will create pressure to reduce fares. First, further liberalisation and more ‘open skies’ bilaterals will remove any vestiges of tariff controls while encouraging the launching of new airlines and the expansion of existing airlines onto new routes from which they were previously barred by the regulatory regime. Second, low-cost low-fare airlines will increasingly impact on international air routes, snapping at the heels of the established major carriers. Till the mid-1990s airlines identified as ‘low cost’, such as Southwest or the former Valujet, had been confined to United States domestic operations. They achieved much lower costs by introducing new operating practices and different service standards. From 1995 onwards several new European airlines, such as Ryanair or easyJet, adopted ‘low cost’ economies and entered European international markets. Offering much lower fares, their market shares increased rapidly and before the end of the decade such established carriers as British Airways and KLM were launching their own ‘low-cost’ subsidiaries. The spread of ‘low-cost’ airlines to medium-haul international routes and possibly even long-haul will increase the downward pressure on fares. Third, during the early years of the new millennium there will almost certainly be over-capacity in many markets as the aircraft ordered in the good years from 1995 to 1998 are delivered and put into service. Despite the fact that in 1998 several Asian airlines, such as Philippine Airlines, Garuda and Thai Airways, cancelled or delayed the delivery of aircraft ordered a year or two earlier, the indications were that world-wide, the introduction of new capacity in the period 1999 to 2002 would aggravate overcapacity trends in several markets. But wherever overcapacity occurs there is a strong incentive for airlines to cut fares to fill up the empty seats. Finally, the devaluation in 1998 by 50 per cent or more of several East Asian currencies, the smaller devaluations in Latin America and the loss of value of around 10 per cent in the euro in 1999 would themselves reduce average revenues in real terms. Fares in devalued currencies cannot rapidly be adjusted sufficiently to compensate for the revenue dilution. Late in 1998 Airbus Industrie was predicting that average yields would decline in some markets by as much as 30 per cent in real terms over the following twenty years.
The downward pressure on yields will in turn make cost reduction a major priority for all airline managements. Cost cutting is no longer a short-term strategy to deal with short-term economic downturns in the airline business. Cost reduction has become a continuous and long-term necessity for financial success. The aim must be to continue and to reduce unit costs. The long-term stability in the price of fuel will help, but it is not enough. The focus of cost reduction strategies will inevitably be on reducing labour costs, which for most airlines represent 25 to 35 per cent of total operating costs. Labour is also a major cost differentiator between airlines competing in the same markets, since so many other input costs, such as fuel, landing fees, aircraft purchase and ground handling, will be broadly similar. Airlines will try to reduce labour costs first of all by improving labour productivity through reductions in staff numbers, by negotiating work practices and by changing business and service processes. This is unlikely to be enough. In order to cut labour costs more dramatically airlines will increasingly try to outsource what were, hitherto, in-house activities. They may even ‘relocate’ many key functions to low-wage economies or employ flight or cabin crews from these countries. The higher the wage levels in an airline’s home country the greater will be the pressure to relocate labour-intensive activities to countries with low wage structures. The dramatic devaluation of several East Asian currencies in 1997-98 makes these countries very attractive as sources of labour for Japanese, European and United States airlines with high wage rates.
The strong pressures to reduce unit costs will also push airlines to re-examine another major cost area, that of sales and distribution. At the same time the industry will become more consumer-oriented and ‘the customer will be king’. As part of this process there will be growing ‘disintermediation’ of airline distribution systems, with airlines bypassing the traditional travel agent to deal directly with their customer. This will be done through the use of the Internet, electronic ticketing, telephone sales and other direct sales methods. Ticketless, paperless travel will become normal. This is, after all, one of the lessons that can be learned from the low-cost airlines. The development and widespread use of so-called ‘electronic commerce’ will revolutionise the selling and distribution systems used within the airline business, while at the same time reducing the commissions paid to travel agents. Since agents’ commissions may account for up to 12 per cent of total operating costs, the scope for cost reduction is substantial.
In the early years of the new millennium, the airline industry will also have to face up to numerous problems arising from the inadequacy of the aviation infrastructure in several parts of the world. Continued growth at around 5 per cent per annum will put the existing aviation infrastructure, that is, the airports and the air traffic systems, under considerable pressure. In many parts of the world they may be unable to cope because of inadequate funds for investment, lack of political will or, in the case of airports in Europe and some other countries, through lack of suitable land available for the construction of additional runways. For many airports close to built-up areas the situation will be made worse by pressure from strong environmental lobbies opposed to further expansion and, in some cases, campaigning for a reduction in the current number of air traffic movements. Governments and airlines will increasingly have to look to developing satellite airports close to major conurbations either on what were previously secondary minor airports or airfields or even on military airfields no longer required by the armed forces.
Where airport capacity cannot be increased then access to runway slots will be at a premium. Airlines which through the existing grandfather rights control these slots will enjoy a major competitive advantage. This is particularly so at major hub airports where the base airline together with its alliance partners and franchisees may effectively control 60-70 per cent or more of the total available slots. For instance, at Schiphol, KLM and its partners have over 70 per cent of the scheduled slots and a very high proportion of the charter slots. The shortage of runway slots will reinforce the competitive strength of airline alliances. Attempts to open up the system of slot allocation by abandoning the grandfather rules are unlikely to be any more successful in generating real competition than they have been in the past. But more open and transparent slot auctions and/or secondary slot trading may be considered. How to ensure greater competition when slots are in short supply will be a key issue in the years to come.
In the case of air traffic control, the need to improve its efficiency, to find adequate funds for investment and to overcome interface problems between neighbouring states will push governments to privatise or partially privatise their air traffic services. The UK government was in the process of doing this in 2000 by selling off 46 per cent of the National Air Traffic Services (NATS). Once this happens and the implications are absorbed by other governments and service providers there will be a rush to further such privatisations. The privatisation of the British Airports Authority in the UK in 1987, the first airports to be privatised, was followed five years later by a deluge of such privatisations. The same will happen once NATS is privatised, but the follow-up will be more rapid.
The environmental issues pose a further and potentially an even greater threat to the airline industry. Moves are already under way within the European Commission to assess the feasibility of charging airlines for the pollution created by aircraft emissions as a way of inducing a reduction in engine emissions. While currently there are technical and political difficulties in imposing any such charges through a fuel tax, the concept of ‘polluter pays’ has been embraced. If during the first decade of the third millennium multinational agreement is reached on this issue, the consequences for airline costs will clearly be adverse.
The airline business in the twenty-first century
In summary, the foregoing analysis suggests that the following key developments and factors will underpin the growth of the international airline business in the first decade of the 21st century:
- While longer-term growth over the years to 2010 as a whole will average close to 5 per cent per annum, growth rates will differ markedly between key markets.
- The period 2000-02 will be very difficult and critical for many airlines because of overcapacity, falling yields and relatively high fuel costs. All airlines will be adversely affected, but state-owned airlines in East Asia, Europe and the Third World will find in particularly difficult to survive. Already early in 2000 Canadian Airlines had to be rescued from collapse by Air Canada while Swissair bought a 34 per cent shareholding in Air Portugal in order to prevent its demise. Olympic Airways was looking to British Airways to save it by injecting desperately needed capital. Both Garuda and Philippine Airlines, like Olympic, were being managed by foreign airline executives. More such rescues are likely to be needed. Many airlines operating in 2000 will no longer be flying in 2010 or will have been absorbed by larger carriers.
- The liberalisation of the existing regulatory constraints on the operation of international air services will spread to areas and markets hitherto unaffected. Restrictions on market access, on capacity, on pricing and even those on ownership of airlines will be progressively eroded. Real ‘open skies’ will be replaced by totally ‘clear skies’. The airline industry will become a truly global business.
- Liberalisation in general, together with the abandonment of ownership restrictions and the privatisation of airlines hitherto government-owned, will accelerate the process of industrial concentration within global alliances. After some early instability, the alliances will become increasingly integrated and dominant. The three largest alliances will between them carry over 50 per cent and perhaps as much as 60 per cent of the world’s air traffic and will totally dominate certain markets.
- Governments and regional authorities, such as the European Commission, will attempt to control possible abuses of such dominance. This will be done by trying to ensure that the competition rules of major regions or countries, such as those of the United States and the European Union, converge as much as possible.
- There will be strong downward pressure on fares and cargo tariffs. Average airline yields will continue to decline in real terms. The drop in yields will be most marked in the early years of the decade because of overcapacity resulting from-ordering in the mid-1990s and from ‘open skies’. New ‘low-cost’ carriers will also help erode fare levels, especially in Europe and later in other regions such as South East Asia.
- Falling yields will reinforce pressure to cut unit costs. Cost reduction will become a long-term and continuous prerequisite for financial success. Airlines will be helped in this by the projected stability in the real price of fuel. The main emphasis will be in reducing the cost of labour through staff reductions, improved work practices and outsourcing, not only of functions such as catering but even the actual flying, to lower-cost operators. Airlines will also increasingly relocate certain activities and employees to low-wage economies.
- In order both to reduce costs and to improve service to customers, airlines will increasingly use electronic commerce not only to sell and distribute their products, but also in their business-to-business relationships. E-commerce will in turn revolutionise the customer-airline relationship and put traditional travel agents and freight forwarders under pressure to adapt to a new reality.
- The continued growth of air traffic at about 5 per cent per annum will place airport and air traffic control systems under tremendous pressure, especially as current capacity is already inadequate in many airports and flight regions. Problems will be aggravated by pressure from environmentalists for the reduction both of aircraft noise and aircraft emissions. To ensure adequate airport capacity is available where new runways cannot be built at existing airports greater use will be made of satellite airports, many of which will be on former military airfields. New ways will be explored for allocating runway slots between airlines where demand exceeds supply. The privatisation of air traffic control in the United Kingdom in order to ensure adequate investment will lead to further such privatisations in other countries.
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