Can airline alliances take the next step and act like a single commercial business? Frank Berardino and Chris Frankel chart a possible route.

Last month, in a report entitled "Keeping the score", USaviation consultancy GRAlaid out the first phase in a strategy for maximising the profits and benefits from an airline alliance. That centred on creating a common score-keeping system to track the alliance benefits and costs.

A key to success is the use of a facilitator who helps the parties build the score-keeping system. A prime objective of the partnership is to maximise joint benefits, subject to all parties being better off than they would be in their next best alternative. Such a partnership has the best chance to be stable and succeed since all members can see that they are clearly better off within the alliance.

The second phase, covered in this report, outlines strategies to move towards the ultimate goal of partners working together like a single entity.

The basic lesson from any industry is that alliances are inherently unstable, and the airline business is no exception. The problem is that some alliances clearly have a better chance of working than others. The ideal is for a union between complementary companies of about equal size and strength, with a shared common goal and mutual respect. In reality that may be hard to achieve.

If there is an imbalance between the would-be partners in terms of strength or relative size, it can still be corrected. Experience suggests that the clearest way to overcome such a mismatch is for the bigger, stronger player to make an outright acquisition of its smaller partner. But, to date at least, airlines have not had the luxury of this option, hemmed in by national ownership rules and competition concerns.

Despite this constraint, alliances remain a commercial necessity for the airline industry. In a highly cyclical business, with its issues of market and airport access, the benefits of knitting together a global network of partners is hardly in dispute. There is therefore a fundamental need to find a mechanism by which a potentially diverse group of carriers, can cooperate successfully.

A possible first phase for creating such a working relationship was described in Airline Business September 1998. That dealt with how carriers learn to cooperate by building a new score-keeping system that keeps track of the benefits and costs flowing to each of them through the strategy adopted by the alliance. Early on, most of these activities will involve code-sharing, negotiating pro-rates for shared flights, laying down common services, linking information systems and (for those with antitrust immunity) setting prices. The partners also work out the net benefits of the "next best alternative" available to each partner and use that as a basic principle. Each partner should be sure that it is better off than if it pursued that next best alternative.

A great deal will have been accomplished in Phase One:

* A rudimentary score keeping system will have been developed to estimate and keep track of the benefits of the alliance.

* In creating this system, the partners will have developed a useful working relationship and way of guiding their decisions based on facts and a common set of information which can be expanded on.

* Many of the natural barriers to close interaction that are common in such alliances will have been avoided.

The benefits enjoyed by the partnership at the end of Phase One define a new "future" base case. The objective of the partnership in Phase Two will be to improve on this performance.

A key part of this first phase, carried out by a third party facilitator, will have been to assemble all the facts and organise them in a transparent way. That process will continue. Each partner then knows that the minimum payoff target is at least as good, and hopefully much better, than the next best alternative on offer. This should produce the confidence to go to the next step: taking actions (subject to constraints) that replicate the behaviour of a single firm.

Maximising joint benefits

In the second phase, the partners will have gone beyond making the alliance work. Now the aim is to establish mechanisms for extracting the maximum benefits. That means coming as close as possible to acting like a single firm. In essence, cooperating on both revenues and costs, and finding ways to invest in individual companies for the common good.

Conceptually, the partners want to work through a programming problem with a host of constraints - labour agreements, fleet orders, other contracts and more. The objective of the problem is to maximise benefits - defined as pre-tax joint cash flow. Building upon the first phase the partners will:

* Define the constraints under which each is working.

* Share detailed cost data.

* Share information on future commitments, including aircraft acquisitions.

* Share market intelligence on necessary or attractive changes in service offerings - flights, prices and service amenities.

* Share information on future schedules, including anticipated fleet changes.

The next step will be to use the programming model (or its equivalent) to search for alternative actions that increase total joint pre-tax cash flows, subject to the constraints.

The partners should explore the full range of revenue enhancing and cost reducing options and evaluate the effects on joint pre-tax cash flow. The score keeping system will have to be expanded to track additional revenue and cost categories. The score keeping will then be used to assess the impact on partners of each action taken and the sum of all the proposed actions. As a principle, in negotiating the distribution of benefits, no partner should be worse off than the new future base case.

Whether or not the partners actually build a programming model, this formal process for developing the future base case, sharing information, and then evaluating other actions to increase and share joint profits is the key to both realising significant benefits and distributing them. So long as each partner continues to believe that the alliance produces more net benefits than the next best alternative, the alliance should thrive.

Over time, this formal process provides the partners with the best chance of realising a substantial portion of the benefits that would accrue to a single company. Ultimately, this process will make it easier for partners to act like a single company - develop joint purchasing programmes, including standardising on fleet types and service amenities, create a joint schedule designed to take advantage of the entire partnership network, and an agreed upon format for making capital expenditure decisions. Each step will strengthen the partnership which should improve its performance relative to its alliance rivals.

This formal process will continue to benefit from the participation of a neutral third party who can assemble and organise information in a transparent way and help the partners work through the consequences of their actions. Full information sharing is the only way the partners can hope to act like a single firm. The neutral third party provides a critical mechanism for assembling, organising and analysing this information.

Organising principles

Phase two is meant to help the alliance act as much as possible like a single company, but is that a realistic goal? After all, there is a yawning gap between the initial step of putting together an effective code-share alliance and going on to act fully in the common interest where literally everything is open for discussion and action. What are some of the other key organising principles of a phase two alliance?

* Exclusivity: All members must sign exclusivity agreements essentially pledging to code-share and other allegiances with the alliance. While there may be some local exceptions, it will be impossible to operate like a single company without such an agreement.

* Long-term contracts: A linked requirement is that all members sign a long term alliance agreement in the order of 10 years. No partner could be expected to make significant commitments to the alliance without an appropriate long term payout period.

* Costly exit penalty: A carrier wanting to leave the alliance should agree to pay a breakup fee to the other members for the lost opportunity it is imposing on its partners. While this will clearly be a matter for tough negotiation, a contingent claim will provide a significant incentive for continued participation and cooperation.

* Costly ejection penalty: A carrier should be compensated if it is a cooperating member but is nevertheless asked to leave the partnership; clearly, this and the previous exit election item can be directly related to the opportunity foregone by the partner, an item that will be constantly updated in the score-keeping system.

* Agreement on accounting principles: In order to make intelligent strategic decisions, the partners will need to speak a common accounting language, starting with some common way to look at route profitability; this is an area that should be the subject of a joint audit, perhaps led by the neutral third party; until these matters are resolved, it will be difficult for the partners to agree on the consequences of proposed actions, especially with respect to cost implications.

* Participation in the same equity markets: The partners should make it a long-term goal to have each of them individually participate in the same equity markets. For example, each member might seek a listing on the US stock marekts either directly or via depository receipts.

A key benefit here is to get feedback on the effectiveness of the alliance via efficient capital markets. Common participation should also address any remaining accounting issues.

* Partnership profit sharing: A formula for allocating group benefits back to individual members will need to be devised in order to underscore the mutual benefits of the alliance to each of the partners. This formula for allocating profits or "dividends" may based on a composite of individual carrier performance measured against agreed performance objectives, as well as overall group profitability. Templates for such a performance driven redistribution of benefits have been in place for some time at large, global consultancies and accounting firms, whose similar objectives include motivating and recognising individual performance from the partners, while distributing the overall profits from the enterprise.

* Commitment of resources: A final principle must be the willingness to commit capital and human resources to the partnership.

Collective long-term view

In summary, the second phase of alliance building, if properly managed, has the potential to take group performance closer to that enjoyed by a single integrated business. The yardsticks are the usual ones of profitability, return to shareholders, consumer satisfaction, employee well-being and more. However, this potential is only likely to be realised once incentive and governance issues are addressed. In short, once the alliance group has been refashioned from a federated structure towards one which approximates to an integrated single entity.

To achieve this status will require a collective, long-term view, with significant commitments in areas such as exclusivity, profit sharing, and resource allocation, to name but a few. Such an interwoven association may preclude partner exit or ejection, except perhaps for the very largest, or strategically desirable carriers.

Taken as a whole, these common values and joint levels of commitment, will pose a significant challenge over time to any alliance group, with or without a third party facilitator. As explained last month in describing the first phase, non-competing airlines of about the same size will have the best chance to succeed. The rewards of succeeding are lasting, superior competitive performance and an enviable capacity to anticipate, and adapt to, market changes. In short, the individual members get more from being within the alliance group than they could ever hope to achieve as an outsider and they are able to point to hard evidence that this is the case.

Source: Airline Business