Isao Kaneko: Domestic union at Japan Airlines

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By Nicholas Ionides in Tokyo

The merger of JAL and JAS in 2002 to form the world's second-largest carrier has given the merged group some much-needed balance

Late in the spring of 2001, Hiromi Funabiki, then chief executive at Japan Air System (JAS) suggested to Isao Kaneko, his counterpart at Japan Airlines (JAL), that the two airlines merge. Kaneko thought it sounded like a good idea and agreed to begin serious discussions with the JAS chief after the peak summer travel period was over. Little did he know that subsequent events in the global airline industry would prove a merger to be not just a good idea, but critically important.

Although by far the biggest airline group in the country, JAL was at the time only slightly larger than JAS on the domestic front, with a local market share by passenger numbers of 25%, compared to 24% at JAS. But both JAL and JAS were far smaller in the domestic market than All Nippon Airways (ANA), which then commanded around 48% of the second-biggest aviation market in the world after the USA.

With the international market already showing signs of weakness early in 2001, Kaneko knew that JAL could not continue to rely so heavily on overseas traffic for its future fortunes. But the peculiarities of the Japanese operating environment made it effectively impossible to grow its domestic base.

Congestion is a chronic problem at key Japanese airports. As part of the government's phased deregulation of the domestic air market, many of the scarce new slots that have become available in recent years at busy facilities like Tokyo's Haneda have been set aside for new entrants. This decision resulted in the the late-1990s launch of new carriers, such as Skymark and Air Do.

Exactly two months after the 11 September terrorist attacks, the merger plans were confirmed. JAL and JAS would be combined through a stock transfer, creating one of the world's largest airline groups, employing more than 52,000 people. In 2002, as US airlines saw their business deteriorate drastically, the enlarged JAL Group became the world's second-largest carrier in revenue terms, only just behind AMR/American Airlines.

Regulatory approval for the merger - which in reality represented a takeover of JAS - was granted in the first half of 2002, allowing the two carriers to be brought under a joint holding company in October that year. Since then they have been progressively integrating systems and services. From 1 April, the JAS name will disappear and operations will fall under two divisions: JAL Domestic and JAL International.

Kaneko, now 65, says the troubles that have faced the industry since the merger plans were announced, including the lingering effects of the 2001 terrorist attacks, the October 2002 Bali nightclub bombings, the war in Iraq and most recently the SARS outbreak, are "proof that our decision was right".

Outside influences
"The old Japan Airlines was dependent on international operations for about 70%, so such incidents like 9/11 or the Iraq war affected our revenue and profit very much. We were very much influenced by such outside incidents," says Kaneko, speaking at the holding company offices in Tokyo's Shinagawa district, now under the banner of Japan Airlines System Corp.

"Most major US airlines depend on domestic operations for about 70% of their passenger revenue. So we need to have a stable market of Japanese domestic operations," he adds, to correct this "revenue imbalance".

"Because we could not increase domestic flights, it was of benefit for JAL and JAS to integrate, to have the even share with ANA to compete in the domestic market. Without integration, the business prospects for both airlines were poor, as there is not sufficient domestic airport capacity to permit expansion."

Kaneko says the merger has achieved the desired results, as the two entities have increased their combined domestic market share from the 49% they had when their joint holding company was formed, to 50.6% in the first half of the current 2003-4 financial year, with ANA falling to 46.2%. JAL Group in the last fiscal year to March 2003 also earned 48% of its passenger revenue from more stable domestic operations, compared with just over 30% before the merger.

Meanwhile, although new entrants such as Skymark and Air Do have had some effect on the market through heavy fare discounting, their financial impact on the incumbents has been limited. This is due to Japan's perennial slot shortage, which has prevented them from growing rapidly. "Domestic deregulation therefore existed in theory, but not in practice," says Kaneko.

ANA formally opposed the merger of its two main rivals, arguing it would be anti-competitive and not in the best interests of consumers. To pacify Japan's Fair Trade Commission (FTC), JAL and JAS agreed to reduce "normal fares" by 10% and give up a handful of valuable slots at Haneda airport to new entrants.

Passenger benefits
Although the enlarged airline group this past summer won approval to return domestic fares to roughly pre-merger levels, Kaneko is adamant that, contrary to what ANA claimed, passengers have benefited from the merger. "After we integrated the competition became more fierce between the two major airlines," he insists.

For its part, the JAL Group estimates that, while the Haneda slots sacrificed to secure regulatory approval for the merger will cost it around ¥2 billion ($18.5 million) in lost revenue in the 2005-6 fiscal year, "the benefits of integration are of course greater". Specifically, Kaneko says the merger is expected to boost net revenue by ¥19.5 billion in that same year, which also marks the completion of the integration. It will also result in cost savings of around ¥61 billion, mostly from reduced property rentals, the elimination of 3,500 jobs, fleet reduction and reduced maintenance costs.

One of the factors behind the forecast revenue growth is an improvement in the type of passengers the larger JAL Group is able to attract, with its domestic route network now the biggest in the country. While international yields remain weak, domestic yields are improving, adds Kaneko, in part because JAL and JAS are together able to attract more individual passengers than group travellers, which he says is a much higher-yielding type of passenger.

"Before the integration, about 70% of ANA's passengers were individual and about 30% were group, but for our case 60% were individual and 40% were group. After the integration it is getting closer and closer."

The carrier says there has been an average one to two point increase in the individual passenger ratio, which after the completion of the integration in fiscal 2005-6 is expected to rise to 65%. "This five percentage-point increase of the individual passenger ratio will benefit us by ¥22 billion," says Kaneko, who adds that eventually the group hopes 70% of its domestic passengers will be individual travellers.

"That's a real big thing," he says, adding that it could never have been realised had the merger not gone ahead. "Our average yield in domestic operation is going higher and we estimate a total average increase this year of about 5%." He attributes much of the improvement to a major route restructuring. The group now serves 176 domestic routes connecting 60 airports, and ended duplication between the former rivals in 2003.

JAS now operates on secondary domestic routes, with JAL having taken over the country's dense trunk routes. That comes ahead of the full integration under JAL Domestic in April, when only JAL flight codes will be used. They have also integrated international routes - on which JAS was a minor player, serving only South Korea and China.

The two have also merged their respective package tour subsidiaries, unified passenger sales and marketing activities, integrated ground handling operations and consolidated reservations and sales centres. Integrating IT, such as reservations and check-in systems, will start in April, based on JAL infrastructure.

Labour integration
One thing of which Kaneko is particularly proud is the fact that JAL and JAS have managed to avoid the labour troubles common for other airline mergers. He says this was avoided by keeping the two pilot seniority systems separate, as well as maintaining all other employee wage systems and working conditions as they were before. There have also been no mass layoffs. "We will integrate these factors at some point, but we are not in a hurry," says Kaneko, adding that "so far the integration has been quite smooth".

Another major challenge facing the merged carrier is to integrate and rationalise the respective fleets of the two airlines and their subsidiaries. The goal is to reduce the number of active aircraft types from today's 16 to 11 by 2006, retiring McDonnell Douglas DC-10s and Boeing MD-11s, NAMC YS-11s, BAe Jetstream 31s and Airbus A300B2/B4s. As of early 2003, the two carriers and their subsidiaries operated 286 aircraft. The plan is to reduce this to 276 by the time that the integration is completed in March 2006, with retirements due to outstrip incoming new aircraft.

On order are Boeing 747-400s, including freighters, as well as 767s and 777s, Bombardier CRJ200s and Dash 8 Q400s. JAL is also seen as a prime candidate for Boeing's proposed 200- to 250-seat 7E7, and Kaneko admits the airline is studying whether to acquire the new type. However, he says JAL is in "no hurry" to replace its older 767s or the A300-600Rs it inherited with the JAS takeover.

Domestic downsizing
JAL is one of Boeing's biggest customers and has never ordered Airbus aircraft, although Kaneko says the carrier is considering the A380 for international services. But against the hopes of Airbus salesmen, Kaneko sees no need for the A380 on domestic routes. Indeed, predicting congestion relief at domestic airports, he foresees "downsizing" the aircraft that connect them.

Currently, JAL and ANA are unique in operating high-capacity 747s with over 560 seats on domestic routes. A sign of the congestion is the fact that aircraft serving Haneda currently have an average of 330 seats. This compares with London Heathrow, where domestic operations are flown with aircraft averaging 140 seats, or New York Newark, with 110 seats.

"Now slots are very much limited, so we have to use larger aeroplanes," says Kaneko. But the government is moving ahead with plans to add a fourth runway around the end of this decade, which will open up new slots and create new opportunities for expansion. Around that time, the JAL Group intends to revamp its single-aisle fleet of more than 60 Boeing 737-400s and Boeing MD-80/90s.

"If the fourth runway is completed and we have enough slots, we will need more frequency rather than having the big aeroplanes," Kaneko says, adding that with the traffic demand, "I really don't think we need an aircraft [like the A380] in domestic operations. As for international operations, we know that competitors like Air France, Lufthansa, Singapore Airlines, Malaysia Airlines and Korean Air are going to purchase it, and we still have to study the effects on service, both on unit costs and service standards. So we have not decided yet, it is still under study," he says.

Airline partnerships are one merger issue that has not proved a problem. JAS had few ties with foreign carriers and JAL has long been sceptical of multilateral alliances. Indeed, of the world's top eight passenger airline groups by revenue in 2002, it was alone in not being part of a global grouping. Kaneko says the JAL Group is closely watching the changing make-up of alliances, but will maintain its cautious view towards membership.

That said, JAL has long been seen as a potential member of oneworld, as it is especially close to members of that grouping, with links to members such as Cathay, Iberia and Qantas, and a close tie with American Airlines. Kaneko says that "of course we are studying" whether to join an alliance, although there is no plan to do so at this time. "We have been enjoying the effects of the bilateral alliances with 21 partners," he adds. "It has worked very well so far."

But he indicates that recent developments relating to the SkyTeam Alliance, of which neighbouring Korean Air is a member, are making JAL take a closer look at all the global groupings. SkyTeam founding member Air France is planning an equity-based tie-up with KLM that will bring the Dutch carrier into the alliance, while KLM partner Northwest is also looking at membership. "That will make SkyTeam very strong," says Kaneko. There is also reason to worry about the Star Alliance in which ANA and South Korea's second carrier, Asiana Airlines, are members.

All positive notes aside, it must be said that the current 2003-4 financial year has been dreadful for the group, mainly because of the impact on Japanese outbound travel of the war in Iraq and the SARS outbreak in key markets. These factors meant that total operating revenue fell 13% to ¥944 billion for the first half ended September, with the group posting an operating loss of ¥48 billion. This compares with an operating profit in the same period last year of just under ¥40 billion.

Because SARS never landed in Japan, the losses mostly came from international operations, as overseas passenger numbers fell 34% to just over 4.9 million and international passenger revenue plunged 29%. Conversely, with more Japanese electing to stay at home, the number of domestic passengers carried increased 2.7%, to 24.3 million, helping domestic revenues to rise by 4%.

Hesitant travellers
Although the SARS outbreak was contained in all affected areas by early July, Kaneko says JAL continues to be hurt by it, as Japanese travellers are still generally hesitant about going abroad. "The market is still not so good," he says. "It is recovering but the pace is not as speedy as we expected. We hope that the total demand will be restored by the end of this fiscal year, [because] we are suffering, and this year's revenue is lower than we expected."

Earlier in 2003 JAL Group asked for government help and got it, as did ANA. JAL was given ¥70 billion in low-interest loans from the state-run Development Bank of Japan (DBJ) while ANA was given ¥15 billion. Kaneko says that because of SARS and Iraq, JAL has estimated a revenue shortfall of ¥162 billion for the year to March and a negative impact on income of ¥115 billion. The government loan and stepped-up cost-cutting efforts should help reduce the impact on earnings to around ¥73 billion, however. An operating loss of ¥48 billion and a net loss of ¥65 billion are still being forecast for the fiscal year.

While not everything has worked out as expected for the JAL Group, Kaneko says the troubles this financial year are the result of factors outside its control. He is also not having trouble sleeping over the decision to merge with JAS. Indeed, he says, had there not been a merger, JAL with its heavy reliance on international operations would have been left in a much more troubling financial position.

"For the short term, especially this fiscal year, we are going to have a deficit, because of the Iraq War and especially SARS," says the chief executive. "But for the longer period, the medium and long term, we are going to benefit from the integration."

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