ANALYSIS: Capacity grip tight on transatlantic market

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Alliances are turning a corner over the North Atlantic. The days of capacity growth that followed open skies and last year's improving economic prospects have been replaced by a more guarded approach to capacity and revenue.

"Capacity discipline is our key lever," said Richard Anderson, chief executive of Delta Air Lines, when referring to maintaining unit revenues during an earnings call in July. He went on to say the airline would cut Atlantic capacity by about 5% year-on-year during the second half.

SkyTeam member Delta has an immunised transatlantic joint ­venture in place with Air France-KLM and Alitalia. Delta cut capacity over the North Atlantic by 7% in the second quarter compared with an increase of 7.6% during the equivalent period in 2011. Similarly its partner Air France-KLM cut capacity by 7.6% during the quarter. Unit revenues at Delta and Air France-KLM increased by 9% and 9.9% respectively.

"In early 2011, we faced industry overcapacity in the transatlantic market and, in connection with our joint-venture partners Air France-KLM and Alitalia, we have reduced capacity in underperforming markets," said Delta in a stock exchange filing in July.

SkyTeam is not alone in its actions. ­Oneworld member American Airlines cut ­capacity by 9.2% year-on-year and reported an 8.5% increase in unit revenues during the second quarter. However, its alliance and joint-venture partners British Airways and Iberia, both owned by International ­Airlines Group (IAG), increased their total capacity by 4.6% year-on-year during the quarter, albeit at a drastically slower rate than last year's 17.2% increase.

Star Alliance member United Airlines cut capacity by 4.1% year-on-year in the second quarter compared with a 7.3% increase in 2011. It reported a 2.3% rise in unit revenues during the period. Alliance and joint-venture partner Lufthansa reported a 0.7% increase in capacity during the quarter compared with a 10.9% rise in 2011. Numbers for the German carrier include capacity to both North ­America and Latin America.

"We [continue to] trim capacity in the face of Europe's continuing economic challenges," said James Compton, chief revenue officer at United, during an earnings call in July. The airline anticipates a 2.7% to 3.7% year-on-year decrease in Atlantic capacity during the second half and a 2.1% to 3.1% decline for the full year.

Star Alliance member US Airways was the sole US-based carrier to increase capacity during the second quarter - up 1.7% compared with a 9.8% increase in 2011. It expects Atlantic capacity to be flat for the full year compared with 2011. The airline is the only US carrier that is not part of an immunised joint venture and has the smallest operation of the US mainline carriers over the North Atlantic.

These capacity cuts come as passenger ­traffic over the North Atlantic is on the ­upswing. Traffic was up 2.7% to 73.6 million passengers in 2011 compared with 2008, when the first phase of EU-US open skies was implemented. According to IATA statistics that includes all traffic from Europe, Africa and the Middle East as well as India and Pakistan to North America.

IATA reports that demand is slowing this year. Although it does not separate the North Atlantic from other international markets, international passenger traffic increased 6.5% in Europe and 2.3% in North America during the six months ending 30 June compared with 11.4% and 6.3%, respectively, during the equivalent period a year earlier.

Joint-venture alliances carry the vast majority of passengers over the North Atlantic, accounting for 87% of the traffic, according to a recent Deutsche Bank report. This is up 2% from 2010. Star Alliance accounts for 39%, SkyTeam 26% and Oneworld 22%.

Increasing traffic, even if growth is slowing, and capacity cuts are allowing airlines to improve yields and generate more revenue over the North Atlantic. Alliances, especially immunised joint-venture ­partnerships, help further by, as IATA puts it, increasing the density of passenger flows between large and small cities on both sides of the pond.

"[Alliances] are doing exactly what they ­intended to do," says Craig Jenks, president of Airline/Aviation Projects who analyses the transatlantic market. This includes better co-ordination of schedules and capacity while reducing costs by outsourcing various local activities to partners, he adds.

American Airlines provides a good ­example of the benefits of an alliance. Revenue per available seat-mile (RASM) has increased despite negligible capacity growth since the carrier implemented its joint venture with BA and Iberia in October 2010. For example, RASM for its North Atlantic operations was up 3.5% on flat capacity compared with the equivalent period in 2010.

Kurt Stache, vice-president of strategic alliances at American, says leveraging the relationships and home market knowledge of their partners has been "quite rewarding" for all three carriers. For example, American's relationships with local corporates and strong frequent-flier base in San Diego enabled BA to relaunch services from the southern California airport to London in 2011, he says.

American was able to reduce the amount of capital it committed to the New York JFK to London Heathrow route by 10% after implementing the joint venture, according to ­Deutsche Bank's research. This was achieved by co-ordinating schedules with BA that allowed the carrier to remove one aircraft from the route and redeploy it elsewhere. The airlines currently offer 13 westbound flights daily on the route, with about one an hour from 08:30 to 20:00, according to Innovata schedules. "[The joint venture] is proving to be a resounding success," said Willie Walsh, chief executive of BA and Iberia parent IAG, in a speech in Washington DC in July.

Delta, United and their respective joint-venture partners are also reaping benefits from the alliances. Delta says its venture with Air France-KLM and Alitalia allows for improved pricing and capacity planning that is in line with demand and the cost of jet fuel. The airline says the partnership generates about $10 billion in annual revenue.

"Our quality of yield has greatly improved with the added value of multi-brand selling plus the improved choice of a joint network," says Michael Erfert, director of alliance and business development at Lufthansa.

Joint venture alliances have proved so successful at improving margins for airlines that long-time non-aligned carriers are reassessing their status. Virgin Atlantic was long the poster child of these carriers, but had a change of heart after American and BA's co-operation was approved in 2010. Its problems have intensified since the purchase of BMI by IAG for which it relies on short-haul feed.

Virgin Atlantic hired Deutsche Bank to conduct an internal review of its operations, including evaluating a possible sale or alliance. No decision has been made, but Virgin continues to evaluate its options.

Deutsche Bank says non-aligned carriers that are neither low-cost or mainline are the most likely to feel pressure from the North Atlantic joint ventures. It names JetBlue Airways and SAS (a member of Star but not in a joint ­venture), in addition to Virgin Atlantic.

Joint-venture alliances are increasingly adept at adjusting capacity and routes over the North Atlantic to match demand. This year's capacity cuts demonstrate airlines' rapid responses to demand signals - in this case, the expected impact of worsening economic conditions in Europe on demand - but routes are increasingly being tailored to what fits the partnership best.

"There has been a disproportionate ­increase in hub-to-hub routes rather than hub-to-spoke routes," says Airline/Aviation Projects' Jenks. "This is a measure of the strength of alliances." Airlines eliminated 13.5 hub-to-spoke or point-to-point routes over the North Atlantic while they added three hub-to-hub routes during the second and third quarter compared with the equivalent period in 2011, according to his research. There was a 2.4% year-on-year net decrease in capacity.

United's recent announcement that it will end flights between Houston Intercontinental and Paris Charles de Gaulle in September is an example of this alliance strength, says Jenks. There was likely to be a significant decline in connecting passengers after Continental, which merged with United in 2010, left SkyTeam and joined Star a year before the merger, he adds. This would have reduced the viability of the route, where the airline competes with Air France. Continental launched Houston to Paris in 1992 and joined SkyTeam in 2004.

Delta's service between Memphis and ­Amsterdam is another example, says Jenks. The carrier will end flights in September as it slowly unwinds its hub in Memphis, despite Amsterdam being a large hub for its partner, Air France-KLM. The Tennessee city's ­proximity to Atlanta makes the route "redundant", he says. Northwest Airlines, which merged with Delta in 2008, launched the route in 1995.

Small and mid-size cities on both sides of the Atlantic have been hit the hardest by this trend. Non-stop transatlantic flights to Bristol, Budapest, Hartford and London's Stansted airport have all been replaced by connections in recent years.

"The pattern you find here is that you fly into your partners' hubs," says American's Stache. "Smaller cities are going to be dependent on both local traffic and transfer traffic, and without the transfer traffic, it can get difficult to make work." For example, American ended flights between Budapest and New York JFK after its Oneworld partner Malev ceased operations in February.

Stache notes that American and its partners have also added services on some new routes. These include American between O'Hare and Helsinki and Miami and Barcelona, Iberia between Madrid and Los Angeles, and BA's service between Heathrow and San Diego. Three of these are hub-to-hub and only one hub-to-spoke.

"With a well-run joint venture, you find you can get your customers to those ­secondary cities just as easily through a hub," says Delta.

Lufthansa's Erfert says the introduction of the Airbus A380 to gateways such as Houston Intercontinental and San Francisco was possible because of its cooperation with United, which has large hubs at both airports. Joint network planning enabled United to launch flights between Newark and Stuttgart in 2011, he points out.

The looming question is how airlines' and alliance partners' new-found focus on ­capacity management will perform through the historically slow winter season over the North Atlantic. US majors Delta and United have already announced further capacity cuts for this period, and their counterparts in Europe are expected to ­release their guidance on the issue soon.

Jenks says airlines and alliances are much better at "tailoring capacity to seasonal demand" this year. Last year, he says, alliances had made "little difference" to seasonal ­profitability over the North Atlantic.

That improved margin, as highlighted by Delta's Anderson - especially though the seasonal ups and downs over the North Atlantic - is what alliances are all about.

In an industry with such tight margins, alliances may not be a golden ticket to profitability, but the edge they give in terms of pricing, revenue and cost savings is sufficient to improve margins over the North Atlantic just enough to make them worthwhile.