If airlines are to reduce some of the earnings volatility that has dogged investor confidence in their sector, then they must manage business risk, not just safety and security

Investment in airlines has never been for the faint of heart. Even before 11 September, airlines were far more volatile than other sectors. In fact, carriers have been five times more likely to lose 25% of their value in one month than the average across all sectors in the Fortune 1000. What is more, share value losses have not recovered over time. That raises the old question of whether air transport is simply too volatile by its nature to be anything more than a high-risk gamble for investors.

Some of the risk clearly stems from the industry's flawed and complex structure. Ownership restrictions have prevented the consolidation which could have helped to even out volatility in local and regional economies. More fundamentally, the industry's business model is capital, labour, and technology intensive, increasing the complexity of the risk management challenge.

However, airline risk need not necessarily be unmanageable. There are effective strategies, adopted by other sectors, which can help identify and manage risk. The alternative is volatility of earnings and, therefore, of share prices. In the main, financial markets simply do not trust carriers to produce consistent earnings and, therefore, airline stock trades at a heavy discount. Airline price-to-earnings (P/E) ratios - a core guide to how the market rates future profits potential - are generally half or a third of the market average, a fact often lamented by airline chief executives. However, airlines that have shown consistent earnings have been rewarded with faster stock price growth. For example, Lufthansa's earnings have been half as volatile as Air Canada's over the past 10 years, and its stock price has grown twice as fast. Air Canada now seems to be taking a page from Lufthansa's strategic playbook by diversifying into airline-related services, such as setting up its loyalty programme as an independent business.

Risk management

Airlines have tended to see risk management in terms of hazards, such as the need to protect physical assets. Significant and growing attention has also been given to safety and security issues. Elsewhere there has been some experimentation with hedging financial risks, such as foreign currency exchange rates, interest rates, and fuel prices. These approaches have been successful to an extent, but more aggressive techniques and a wider perspective would greatly increase the benefits. One new concept that can address this opportunity is Enterprise Risk Management, a process of systematically identifying all critical risks, quantifying their impacts, and developing and implementing integrated risk management solutions. Those solutions need to be total - aligning people, processes and technology to maximise enterprise value. Some tenets of this approach include the concepts that:

not all risks are material - it depends on their potential impact on the value of the enterprise; individual risks and their impacts should be evaluated on a portfolio basis to understand and appreciate correlations among risks; risk management is an ongoing process, not a one-time event;

Mercer Management Consulting recently analysed aviation industry risks for the 10-year period from April 1991 to April 2001. The primary risks facing the industry fall into four categories: hazard, strategic, financial and operational. Overall, failure to manage these risks resulted in the evaporation of $46 billion in shareholder value. Interestingly, hazard events, including safety, liability and war, were the least likely to result in value loss. Strategic and financial risks were much more prevalent, accounting for nearly 75% of value loss events during the period.

Strategic risks are defined by business design choices and how these interact with external factors. A challenge from a new form of competition, shifts in customer preference and industry consolidation are all examples. Many of these challenges may be mitigated through traditional responses, such as a change in corporate culture. But other risks can be lessened from the outset through the basic design of the business. For example, Southwest Airlines has a model that attracts customers in good times and in bad because it is simple, and cost and operationally effective. It is also not subject to the reliability problems that bedevil network carriers. Other design choices further lower the carrier's risk exposure. For example, use of secondary airports insulates it from direct competitive pressure and speeds aircraft turns. Low debt levels make the company less vulnerable to interest rate fluctuations. And profit sharing and a fun culture reduce labour difficulties.

Financial risks involve the management of capital and cash, including external factors that affect the variability and predictability of revenue and cash flow - such as general economic conditions or currency exchange rates. Beyond hazard risks, techniques to mitigate financial risks are the most advanced, primarily because there is a large third-party market dedicated to the effort, including banks, credit specialists, derivative markets and others. Financial solutions may include the design and placement of financial transactions, for example, structured finance, derivatives, insurance, contingent financing and debt/equity offerings. Other, new approaches could push thinking even further in this area.

Operational risks arise from the tactical aspects of running the operation, such as crew scheduling, accounting and information systems and e-commerce activities. Many airlines have processes in place to mitigate the most obvious operational risks, such as business interruption, but fail to address more subtle issues, for example working with government to shape regulatory issues which cost millions in operational inefficiencies and legal actions.

Operations can also be reshaped to reduce risk through familiar concepts such as process re-engineering, contingency planning or improved communications. The challenge is to look at risks holistically, as well as evaluating each potential response through the lens of impact on shareholder value. Then strategies can be defined to mitigate risk wherever it resides.

Risk mitigation

Lufthansa's diversification into non-flying businesses was designed to reduce strategic risk and the volatility of its earnings base originating from the passenger airline business. The programme began in 1994 after three years of losses, with four companies being created in engineering, cargo, services and systems. Revenue growth has been highest in the service-related divisions, and passenger airline revenues - 70% of the total in 1995 - now account for 56%. While Lufthansa is still reliant on the air transport sector, it is in a better position to reduce earnings volatility than its competitors. The Swissair group pursued a similar strategy, but a flawed core-company strategy resulted in its demise. Not surprisingly, the only value left in the company after the recent crisis was in the services businesses.

Some airlines have contained strategic risk through aggressive cash management. Most airlines accelerate spending during periods of high growth to acquire new aircraft, upgrade products and maintain labour peace. Airlines with the highest multiples, however, conserve cash during the boom times and invest in the trough. For example, at the depth of the Asian financial crisis, Singapore Airlines initiated hundreds of millions of dollars worth of upgrades to its on-board product, further entrenching its leadership position during the later economic upturn. Another example is the recent order for 100 Boeing 737s with 50 options by Europe's low-cost carrier Ryanair. As it was placed at a time when most airlines are deferring orders and mothballing aircraft, Ryanair was able to negotiate a low unit price.

Hedging is a common way to manage the financial risk of input price changes, and no airline input is more volatile than fuel. Airline executives often comment that hedging is not a core competency, and that as long as competitors are not hedged, it will be a level playing field. Unfortunately, when fuel prices rise dramatically, airlines cannot pass all of the cost on to their customers. This is clear from a Mercer study into the impact of hedging strategies among major airlines for the year 2000, when fuel prices were soaring. While many airlines were able to maintain profits in the face of price increases, more aggressive strategies could have been used to improve results further. If such tools are not further leveraged, earnings will continue to be vulnerable, and shareholders will suffer value loss during volatile periods of supply.

British Airways has a well-developed structure for developing fuel hedging strategies. A Fuel Hedging Committee, made up of representatives from the fuel, finance, treasury and strategy departments, meets on a regular basis to set the company's hedging policy. Operating within limits set by the board, the Committee saved BA over $100 million in 2000. However, in 1999 and 2000, BA held no fuel hedging contracts with terms greater than a year. As aviation fuel prices rose steadily after touching a 10-year low in February 1999, British Airways rapidly lost the benefit of having hedged at this low price. This was evident in the company's results: fuel costs rose in the 1999 financial year by 14%, despite a rise in the average market price of 47%.

However, in the 2000 financial year, BA's fuel costs had risen by 37% while the market average was up 46%. Had BA taken on longer-term hedging contracts in 1998 and 1999, while prices were low, the savings in 2000 and beyond could have been far higher. For example, with a fixed annual fuel price increase of 10% instigated in March 1999, the carrier would have saved $40 million in the 1999 financial year and $350 million in 2000-1.

While BA did not engage in long-term fuel hedging, Cathay Pacific had contracts in place at the end of 2000 hedging a portion of the company's fuel requirements until the end of 2003. Fuel hedging has cost Cathay money in years when prices have been falling (such as 1997 and 1998), but the net effect over the last five years has been a saving of approximately $80 million. In 2000, 15% of Cathay's operating profit was directly attributable to savings from fuel hedging.

New techniques are emerging which should allow airlines to manage other financial risks. One example involves guarantees for credit card transactions. Such a scheme allows an airline to access otherwise unavailable cash, such as credit card escrow funds. Normally, the bank processing a weakened airline's credit card transactions will put all of the funds into an escrow account, to be released as customers use their tickets. This protects the bank against refund requirements should the airline cease operations. In the new arrangement, a guarantor "insures" the refunds to the bank, which then releases the cash in the escrow.

The risk analysis carried out by the guarantor focuses on the likelihood that the airline will fail to discharge its obligations rather than simply its risk of default. Insurance capacity can typically provide a flexible risk mitigation avenue, without exposing the insurer to undue risk of losses.


Of the 45 risk events analysed by Mercer, nearly two-thirds could have been avoided using available risk management techniques. Ten of the events could have been mitigated through traditional means, such as insurance or financial derivatives. Some 14 could have been mitigated by more consistent and in-depth customer analysis, combined with scenario planning and game theory exercises. Finally, an additional eight events could have been mitigated through improved merger integration planning and improved execution.

Given the many new tools available, it is an opportune time for airlines to move to the next level of sophistication in enterprise risk management. The impact of one-time value-destroying events and related earnings volatility would be reduced, and shareholder value dramatically improved. James Lam, former chief risk officer at Fidelity Investments and General Electric puts it well:" Leaders recognise that, over the long-term, the only alternative to risk management is crisis management."

Source: Airline Business