CHRIS TARRY COMMERZBANK IN LONDON The traffic forecasting model developed by Commerzbank and Airline Business highlights the extent to which capacity ran ahead of demand in 1999. But the coming year could bring markets back to balance.

If further evidence was needed over the pain that excess seat capacity can cause, then last year's experience provided a timely reminder. The destructive impact on yields, profits and, most importantly cashflow, have already begun to show through in airline results. More is expected as the full year 1999 figures unwind. The question now is what the future holds for the year ahead?

As revenue managers are only too aware, air travel is a business that works at the margin. After hitting breakeven, as much as 80-85% of any additional revenue will flow directly into profits and cash. So far, so good. However, this operational gearing has a downside too. In an industry where 70% of costs are fixed or quasi-fixed, it does not take much of an imbalance to start producing losses. The experience of 1999 has been a salutary lesson in how damaging that effect can be.

Industry estimates suggest that annual traffic growth for 1999 will be in the region of 5.1%, but the extra volume of flying looks unlikely to have yielded much extra revenue. Predictions are that it will remain more or less unchanged at the $135 billion mark. The result, almost by definition, is a sharp fall in expected profit results, again highlighting the knife-edge instability of the airline operating environment. The North Atlantic is a case in point - little extra revenue and no additional profit is expected to flow from the double digit capacity hike over the summer. Warnings over the need for a little more capacity control have been loud and clear throughout the year, especially, and particularly, as markets are opened up to new competition.

There is clear evidence that it is the degree of excess capacity that exists in a market which determines the trend in yield and ultimately the financial outcome on the revenue side. In a business where it is nearly impossible to fine tune costs, at least over the short term, a sudden hit on revenues almost inevitably follows through with a direct impact on operating profits.

Of course there are those airline executives that will proudly point to the fact that they managed to keep load factors steady despite a hike in capacity. The fact that traffic grew in line with capacity, they argue, proves that the decision to go for growth was justified. That, however, is looking at the equation the wrong way around. It has never been difficult to generate traffic. The question is at what price? The real game is not simply to raise passenger kilometres, but to ensure that this additional traffic adds to the financial performance of the business rather than detracts. The most important relationship is between unit cost and unit revenue. Although increases in capacity will act to reduce unit costs, the presence of additional and, in particular, excess capacity has a damaging impact on yield. More often than not, the negative impact on unit revenues is likely to be greater than the advantage on unit cost.

The evidence from the principal European airlines in the summer of 1999 showed quite clearly the impact of excess capacity. A glance across the experience of the major carriers amply demonstrates the correlation between capacity growth and yield decline. So Swissair and Lufthansa, which raised capacity 12% and 14% respectively, both suffered a dramatic fall in yields of more than 12%. British Airways and KLM, which had kept seat growth at a more modest 3-4%, also saw yields drop, but the fall was at less than half of that level.

The problems of last summer are now fading into history. The real issue now is what this experience tells us about the future - both in terms of what it implies for the summer ahead and what we can learn from it to predict future growth.

Forecasting model

Over the past few months, Commerzbank and Airline Business have collaborated on building a traffic model designed to uncover the underlying demand for key world markets. In essence it provides a figure for the rate of traffic growth which would occur if yields and mix remained neutral. That is a potentially powerful benchmark against which to measure the rates of capacity and traffic that are flowing in the market. The presence of a "gap" between the rate of underlying demand and the traffic growth indicates the market is out of balance - that number is the Traffic Deficiency Indicator (TDI). The model also provides a better understanding, and an early warning, of where pressures are building in the system as new capacity is added.

It is worthwhile reviewing here the main elements and theory that underline the model. The fundamental rationale is that economic growth, measured in GDP, determines the underlying rate of market demand. In this respect, it is little different from most other views on the determinants of traffic growth. However, it is the increased importance given to a number of other factors in the equation where the TDI model differs from the mainstream view and may indeed challenge some long-accepted conventional wisdom.

In reality, the inter-related factors and relationships that determine the reported rates of growth are more complex than suggested by the rule of thumb GDP multipliers usually applied. Recent data from the International Air Transport Association (IATA) quantify what has been gradually becoming apparent, that the influence of economic growth as a traffic driver has diminished. In the 1980s, GDP was estimated to account for 80% of the variation in airline traffic. During the 1990s, this explanatory influence dropped to 60% with a concomitant rise in the power of the yield.

So if yields increasingly regulate growth, the question becomes what regulates yields? The TDI model was built on the founding principle that it is inextricably linked to the degree of excess capacity in the market. This raises the dilemma of what comes first. Is excess capacity driving down the yield? Or are weak market conditions and therefore weak yields, leaving airlines exposed with too much capacity? The answer is probably a mix of factors. Capacity planned for the coming season is clearly influenced by the impact of decisions in earlier seasons. The yield reflects the activity of the sales force and a combination of market conditions plus the nervousness, reality, or bravado of the revenue management department.

There are naturally local influences on local markets which may make them an exception to the general rule. But there is at least one common characteristic that applies to all markets where pricing is subject to the laws of supply and demand. Conditions of excess demand are good for price - conditions of excess supply are not.

To look at this another way, it is possible to argue that the GDP multiplier increases with structural reductions in yield, as well as differences in the maturity of a particular market. It could of course be argued that the airlines in the low-cost no-frills segment have in fact a very high GDP multiplier. That reflects the structurally low yields of the market. Here, however, is a particularly interesting circularity. Starting from a low cost base, airlines in this segment need to use capacity growth to reduce unit costs. That in turn provides further growth, which again helps reduce unit costs and so on until they reach the point where diseconomies of scale set in, as indeed they must.

Immature markets with low levels of competition are amenable to potentially significant hikes in capacity and will continue to show profit growth at the same time. However, there is an important difference between rapid growth in an under-developed market and the growth that leads to an increase in the degree of excess capacity in a mature market. The main focus here is on the latter.

It is clear that as markets become increasingly open, the ability to price lead is reduced, unless there is a qualitative difference in the product offered. While there may be some chance of differentiation on certain long-haul routes, in general the world is following the US domestic lead, where the airline seat is fast becoming and indistinguishable commodity product.

In these conditions, new entrants will bring with them excess capacity. That in turn puts pressure on yield and starts to change the market economics. Given that such competition is set to grow rather than decline, there would seem to be a need for the industry to find a structural solution to the issue.

A key starting point is the need to recognise that fact that pursuing market share for its own sake is not the way forward, unless there is leverage to exert pricing power. This is clear and increasing evidence that such pricing power has already disappeared in the principal markets of the world, especially in the short-haul market and the long-haul economy sector.

Even if this lesson prevails, it will take time for the market to return to balance. The overcapacity problems which emerged last summer had its roots in decisions taken well before the season began. Not only had aircraft orders already been placed, but in the case of the North Atlantic and Latin American markets, decisions had been taken in the previous summer of 1998 to shift capacity out of the depressed Asia-Pacific region.

Similarly, the excesses of 1999 will take time to unwind. Although there are early signs of a better operating environment over 2000 as a whole, the first half of the year is still expected to prove challenging for a number of airlines with a lingering imbalance between capacity and underlying demand.

The TDI model highlights the gaps which opened up during the year. On the North Atlantic, seat capacity was pushed up by around 13% and although traffic also rose in double figures, the underlying demand is estimated at 6.6%. That gives a TDI deficit of more than six growth points. European travel to the smaller South Atlantic markets also remained well out of balance, although capacity cuts between Europe and Asia-Pacific left that segment showing a positive, which suggests that there has been scope for recovery in yields after the bleak outlook of the previous two years. Intra-European capacity growth of 7% has also been within striking distance of underlying demand.

Market corrections

Whatever the current pain, however, the most important feature is that the capacity problem has now been recognised and is in the process being corrected. The first obvious signs of capacity adjustment came from Europe as Lufthansa, SAS and Swissair followed the prudent lead set by British Airways and KLM. Indeed, taken together, the growth in international capacity of Europe's airlines for 2000 is expected to be in the range of 3-3.5%. Clearly a healthier environment.

That trend has now started to produce a corresponding response on the other side of the Atlantic. American Airlines is increasing capacity by a modest 3%. Continental, helped by the earlier-than-expected retirement of its McDonnell Douglas DC-10s, will reduce its growth rate to 4%. United is effectively cutting capacity by 4%, while offering a better quality product with improved seat pitch at the back of the aircraft.

The North Atlantic is not the only market in need of adjustment, but it is a significant bell-weather. For the past 12 months it is has been the battleground on which most of the world's largest intercontinental carriers have chosen to fight and, at long last, there are the first early signs for optimism.

In part, the problems across the Atlantic have been the price to pay for a better balance in Asia-Pacific, as carriers moved their capacity out of the region, causing painful, knock-on effects elsewhere around the world. Now that Asia is showing strong underlying recovery, buoyed by a more robust economic outlook, the good news could continue, but only if the industry remains realistic about capacity growth and resists the temptation to rush back into the region en masse. That, however, would bring at least have the virtue of easing pressures on the North Atlantic.

Besides these shifts of existing capacity within the system, there is also the issue of new capacity coming on to the market as new aircraft come into service in airline fleets. On that score, the industry appears to have avoided a repeat of the over-ordering of the late 1980s, with its subsequent boom-to-bust. All the indications are for a reduction in the rate of net additions to the fleet from the end of 1999 onwards. This rate will continue to fall over the next four years to 2003 as retirements increase.

In all of this, the crucial lesson is to focus on the underlying rate of growth and tailor capacity accordingly. Not all traffic is good, at least for profits, as has been borne out by the operating experience of 1999. The quest for market share is all well and good if it be turned into profit, but that seems like an increasingly difficult trick to pull off against the backdrop of market liberalisation, rising competition and the growing significance of global alliances.

Looking at the present state of play, the industry's objective must be to recover some of its lost ground on yields. That means growing capacity below the underlying rate of traffic growth, at which yields remain neutral. That is the message, now comes the wait for action.

Some comfort can be drawn from past experience. The industry has a propensity to over react to most phases of the cycle, good and bad. The pain of the early 1990s led to a new determination to ensure a more rational approach to capacity. After a prolonged spell of good housekeeping, things once more got out of hand. The expectation is that rational behaviour will break out again. The signs look encouraging for 2000.

For the European majors, the TDI model forecasts underlying traffic growth of nearly 7% on the main international routes. This appears adequately in excess of the planned capacity expansion. Even on a disaggregated basis, with expected growth in the North Atlantic segment of 6.4%, there are grounds for more than just a little optimism that the balance will be restored. Asia is at the highest end of the predictions averaging around 6.7%, which is again comfortably ahead of planned capacity. However, it will not be until the summer season that it becomes clear whether the industry can or will resist the temptation to rush back in.

The US airlines are already retreating a little from their headlong dash across the North Atlantic. In the year to come they should be better placed to exploit growth prospects in their other principal international markets. Underlying growth for the Asia is somewhere close to 6%, as many of the Pacific Rim economies recover, albeit from a very low base. Whether Japan joins the party remains to be seen.

However, bringing the market back towards a better balance is not like turning on a light switch. A better analogy for the trip towards equilibrium is like throwing a large rock into a millpond and waiting for the ripples to settle. This is a slow but successful strategy, provided, of course, that nobody else starts to hurl in unwanted rocks at the same time.

There are plenty of other issues which could yet catch the industry off-guard, such as the ever-present risk of unexpected events in the world economy. There are also cost issues on the agenda such as fuel prices and worrying signs of structural change in short-haul markets as passengers move towards the back of the aircraft. But at least there are grounds for a more positive view on the industry's fundamental equation between demand and supply.

Source: Airline Business