After a largely successful 1998, today's going is much tougher for many major airlines
The airline business has never been the world's quickest to learn the lessons of harsh financial experience. Unable to break free from a boom-bust cycle that can be traced back over several decades, airlines - like ever-optimistic gamblers - go on making the same mistakes.
Or at least they usually do. Twelve months ago, there was ample evidence to suggest that some carriers at last were beginning to take on board the lessons of the past and breaking free of the boom-bust trend. Today, however, several major airlines are again struggling to stay out of the red after seeing their dreams of stable growth evaporate.
So what went wrong? Quite simply, many carriers that should have known better gave in to temptation and ramped up capacity at what turned out to be the most inopportune of moments. The caution evident throughout much of 1998 was prompted by a general fear that the world economy was about to enter a period of recession, or even collapse. But when it became apparent that there would be no more than a slowdown, the airlines - particularly in Europe - reacted by targeting market share through capacity increases.
Analyst Chris Tarry of Commerzbank regards this decision as a major mistake that has left several major players exposed to potentially significant losses. Following the severe downturn of the early 1990s, the airline industry, he contends, entered a "prolonged period of rational behaviour" - only for that rationality to be swept away on the tide of optimism that welled up late last year after airlines decided that the global economy was stabilising.
Subsequent capacity increases, he argues, represent a return to type, as carriers pursue the Holy Grail of regaining what they regard as a "pre-ordained" level of market share, making the prospect of severe and damaging fare wars ever more likely. Tarry suggests airlines are guilty of ignoring two fundamentals of the industry: that traffic is itself a function of economic growth, and that underlying yields are a function of the degree of excess capacity.
In other words, given that they would want to increase capacity in line with demand - ie, with traffic - carriers should do so only when there is sufficient economic growth to justify such a move. Where they over-estimate demand, producing excess capacity, they will inevitably suffer a decline in yields.
Furthermore, Tarry contends, there is no such thing as pre-ordained market share, and rather than chase this Chimera, airlines would be better advised to focus on "maximising most profitable market share", concentrating their energies on activities likely to deliver the greatest returns.
According to this argument, pursuing growth for growth's sake is to enter into a vicious circle. Increasing load factors should not be regarded as an end in itself, because filling aircraft seats is not, in isolation, a difficult task. It can be accomplished by selling cheaper tickets. The trick here is to fill aircraft while maintaining prices - and what matters most is the break-even load factor.
While a general world trend towards boosting capacity beginning late last year is discernible, the true picture is spottier. The impact of capacity increases has been most evident on intra-European and North Atlantic routes, where in the absence of equivalent increases in demand the effect has been to redistribute traffic and thus to kill yields.
The biggest casualty here is British Airways, which increased capacity by 12% over the year. Its profits collapsed from an anticipated £600-£700 million ($970 million-$1.1 billion) to just £225 million, largely due to a 10% fall in yields over the last three quarters, versus an expected fall of about 4%.
Significantly, BA has responded in the most radical manner, announcing a sweeping plan to slash capacity to the bone and trade down to smaller aircraft types in most of its markets, while pledging to upgrade a business class product that is looking increasingly jaded.
When 1998 is considered in its entirety, the impact of these ill-timed capacity increases is not wholly apparent - a buoyant start to the year masks the impact of troubles that emerged in the last quarter. That impact becomes more pronounced, however, for airlines which report according to financial periods straddling the year end. A glance across this year's Flight International top 50 rankings (produced in conjunction with sister magazine Airline Business) also reveals that profit growth was generally flat, as were several other key indicators, reinforcing the impression of an industry on a plateau - generally making only modest gains and apparently at the top of its cycle.
Statistics from the International Air Transport Association (IATA) show that members made a combined net profit of $3.1 billion on turnover of $142.7 billion from scheduled international services last year - down $1.9 billion on the 1997 figure. Capacity grew at 5.2%, significantly lower than 1997's 6.9%, yet passenger and cargo traffic growth, at only 2.2%, still failed to keep pace.
The International Civil Aviation Organisation (ICAO), estimating full group results, anticipates a rise in both operating revenues and operating expenses of 3% over 1997. On average, in dollar terms, operating revenues per tonne/km performed increased from 80.8¢ in 1997 to 81.6¢ last year, and operating expenses per tonne/km rose from 76.3¢ to 77.1¢. The net result for 1998 (including interest and subsidies, plus tax deductions), ICAO says, is expected to be better than in 1997, when it was 2.9% of operating revenues.
ICAO interprets the figures as reflecting "a generally healthy world economy", but adds that setbacks in several major economies, notably Asia, "resulted in a substantial slowdown in traffic growth". Total scheduled traffic increased only 1% in terms of tonne/km performed, while international traffic was up 2%.
The organisation suggests that capacity increases were "kept in check", so that average passenger load factor remained 69%. Total world yield increased 1%, but the key performance indicator declined in the Asia-Pacific and Latin America. Low aviation fuel prices also served to keep costs in check.
In 1998, ICAO figures show that Asia was a case apart, with the region's airlines suffering a year-on-year fall in traffic for the first time in 30 years. Asian carriers showed a 2% decline in tonne/km performed, after achieving an average of 12% growth over the three decades as a whole.
So hard did the Asian decline bite that the region was responsible for the general slowdown in world growth, accounting for one-third of the world total. Europe and Latin America reported growth above the world average, with the Middle East and North America close to average and Africa somewhat below. Numbers of passengers carried rose from 1,457 million in 1997 to 1,462 million in 1998, while revenue passenger km (RPK) was up to 2,630,000 million from 2,573,000 million.
In broad terms, the big US carriers continued to perform well last year, with the exception of Northwest Airlines, which saw its figures mangled by a costly pilot strike. The US majors accounted for five of the top 10 airlines by revenue and for six by net profit, with Southwest Airline's performance especially impressive. Two groups, AMR and UAL, passed the $1 billion profit mark, with the former remaining the world's biggest carrier, boasting revenues of more than $19 billion.
Delta tops passenger table
United Airlines retains the top spot in terms of RPK, flying more than 200 billion, while Delta Air Lines once again emplaned the largest number of passengers at 105 million.
Northwest was the biggest loser last year, with a net loss of more than $280 million, while another US major, Trans World Airlines, still continues to struggle, its losses nudging up to $121 million. The two US carriers and ailing Canadian Airlines aside, however, the roster of loss-makers once again included many Asian carriers, with Malaysia Airlines and Asiana again taking a buffeting, and Cathay Pacific, generally regarded as one of the best-run airlines in the world, turning in its first loss since 1963.
China was also forced to bite the bullet last year. Though its own economy, protected to a large degree from currency fluctuations and stock market shocks, escaped the worst of the Asian malaise, a fall in the number of other Asians travelling to the company inevitably hit home. The situation in Japan was less severe than in 1997, but a price war there - sparked as new start-ups entered the market - means that a full recovery is likely to prove elusive.
Latin American decline
Having improved their performance in 1997, or at least remained relatively profitable, Latin America's airlines were sucked down by the knock-on effects of the Asian decline. Vasp, Aerolineas Argentinas and Varig suffered big losses and Mexico's Cintra holding company saw profits reduced to a fifth of the previous year's total.
Asia's carriers took most of the big hits in 1998, but the changing picture towards the end of the period and into the current year has quickly transformed the industry's outlook in Europe and North America alike. While the capacity ramp-up was in itself misplaced, the Asian situation contributed to its impact in that it led to a transfer of additional capacity from the Asia-Pacific to other arenas.
European carriers therefore increased their own capacities just as North American airlines began to move seats from Pacific routes to the North Atlantic and Asian carriers themselves continued their own redeployment. With hindsight, a major squeeze seems inevitable - yet many airlines gravely under-estimated the likelihood of such an occurrence.
For the current perilous situation in Europe, at least, to be remedied, three things must happen. Firstly, the airlines concerned must cut capacity. Secondly, the European economy must accelerate out of its slow-down and bounce back, as it seems likely to do next year, and - finally - the Asian recovery must take hold, allowing capacity from the Asia-Pacific itself and from North America to be transferred back to routes where traffic has been sluggish.
Mistakes made in Europe seem set to be reflected in the performance of the continent's major carriers this year, with Germany's Lufthansa scaling down expectations from what began as record predictions, newly-privatised Air France struggling once again after knocking itself into better shape, and BA now staring down the barrel of a full year loss.
Commerzbank, which had already revised expectations for the UK flag-carrier down from a £300 million pre-tax profit for the current year (ending 31 March 2000) to one of £159, now predicts that it will take a £7 million pre-tax loss.
Against this background, BA's response is especially important. Tarry argues that for BA, the new strategy "is set to transform the economics of its business", and that this "reflects a fundamental change in attitude of airline industry management". The airline's multi-pronged approach seeks to rein in capacity while also focusing on the point-to-point market and aiming to eradicate non-profitable transfer traffic.
In this context, the unveiling of its new "flying bed" seat and the effective relaunch of its Club World business class product - which had a huge impact when it was rolled out in 1988 - are not mere adornments to BA's core business, but are at the heart of the battle the carrier foresees.
Other combatants are already engaged in the battle for the high-yield business traveller: Singapore Airlines and Cathay Pacific offer bed seats and Virgin Atlantic and others are committed to their introduction. BA, however, is pledged to introducing its new product throughout the front of its aircraft. Although completing the programme will take years, Tarry believes that other majors will be forced to match the UK giant's strategy.
Combined with a fleet renewal programme based on the network-wide deployment of smaller types, Tarry suggests BA's moves to defend its high-price, and - nominally, at least - high-value business market, could allow it to steal a march on its rivals, current agonies not withstanding.
"BA has a two-year lead in all of this because of the position in the overhaul and rebranding of its business product," he says. "Several other airlines have already gone through that, or are some way off doing so, and it may be hard for them to respond."
The question is: has BA got its strategy right, or could its high-risk approach transform a downturn in its fortunes into a major crisis? Lufthansa, BA's biggest European rival, remains pledged to an accelerated increase in capacity, but some analysts expect the airline to ditch this commitment and announce a change of plan when it reports quarterly results this month.
In the USA, where the economy remains buoyant, carriers have been better able to ride out recent difficulties. Yet figures for the second quarter of this year were generally poor, with falling ticket prices eroding profits despite continuing strong demand for travel, and there are now signs that some big US airlines are contemplating moves akin to BA's.
United Airlines recently unveiled plans to rip a row of economy-class seats out of each domestic aircraft while creating a new premium economy class. The strategy is aimed at retaining its hold on business travellers paying full economy fares - and with the importance of the business market to the airline fairly typical (accounting for 9% of its load but 46% of revenues), it seems certain that more carriers will take parallel steps to finally address over-capacity and defend yields.
Source: Flight International