Poor long-term industry profitability, largely the result of mismatches between capacity and demand, can be resolved if carriers learn to use the economic cycle to their advantage, with a more flexible response. Report by McKinsey & Co consultants Steve Skinner and Elane Stock

Airlines are caught in a dilemma. On the one hand, carriers feel intense pressure to grow. On the other, few carriers have ever grown in a value-creating fashion.

As in any industry, profitable growth is key to creating shareholder value. Competitively, the more capacity share a carrier has, the greater its revenue share and hence profitability will be at the city, route and regional level. With these economics, the fear of losing market share is a tremendous incentive to grow. In addition, growth creates value for frontline employees, who get access to better opportunities as the company expands. And customers benefit as growth makes available a broader set of destinations.

Yet among major carriers worldwide over the past 20 years, only British Airways post-privatisation and Southwest have beaten their corresponding stock market index. A cynical observer might even suggest that growing in the typical airline manner only turns a small, low return business into a large, low return business.

What should be done? Staying put does not look like an attractive option. Faced with the need to grow, airlines can either try to build their core business in a way that addresses the fundamental causes of poor profitability, or grow into other businesses where their current capabilities can be leveraged. There are in fact profitable opportunities in both areas. This article will discuss a key to successful growth strategies within the airlines' core business, in other words mastering the cycle. A sequel in the June issue of Airline Business will address external growth.

Boom to bust

Most people agree that the boom/bust airline cycle is the leading cause of poor long-term industry profitability. To grow profitably within the core business, carriers must grow in a way that manages the effects of the cycle. Doing so requires a deep understanding of the drivers of the cycle, and the links between the cycle and company profitability.

Chart 1 illustrates a greatly simplified view of the cycle in action. Profitability, represented as point 1, drives orders for new capacity. As airlines become more profitable, they channel their cash flow into orders for new aircraft to support growth. There is a delay here, since carriers tend to wait and see if the profitability is sustained before committing to orders. After another delay, for production, orders become deliveries which increase capacity.

Depending on demand growth, the supply/demand balance will be altered and pricing levels will be affected, closing the loop again at the resulting profitability. If industry capacity has grown faster than demand, profitability will decrease, and vice versa.

This is an interesting theory, but does it work in the real world? Chart 2 shows worldwide airline profitability, aircraft orders, and deliveries. On the left side, the pattern of orders lagging by 1-2 years behind profitability is very clear. The right side shows the deliveries - after a two-year production delay - coming during the next downturn, which in turn chokes off the flow of orders.


Ideally, the opportunity to reduce capacity through early aircraft retirements and lease returns would help dampen the cycles (Chart 1, point 2a). But most operational costs are fixed in the short term. Combined with the negative impact of reducing individual segments, through lost 'beyond' revenue, this makes capacity less responsive to fluctuating profitability levels. Carriers refrain from reducing capacity in all but the most desperate circumstances. This is rational for individual carriers but, of course, destructive from an industry perspective.

Combined, these relationships dictate that the industry will be naturally cyclical. The only way to quench the industry's thirst for aircraft is for overcapacity to drive down profitability. Since the order to delivery cycle is longer than the timeframe within which demand and capacity can be accurately predicted, the low profitability signal to carriers comes too late. Periods of overcapacity are inevitable. This is a structural fact, which carriers respond to by adjusting pricing levels to stimulate demand, guaranteeing that profitability will continually cycle up and down.


Carriers' recent capacity restraint has been cited as an indication that the industry will become more 'disciplined' in the future. Indeed, orders in 1996 and 1997 represented only 8-10 per cent of the existing fleet; just slightly more than the historical average. But restraint may eventually lead to larger orders when they are finally placed and actually increase the severity of the cycles rather than dampen them. During the relatively prosperous period between 1985-7, orders were similarly restrained and close to historical averages at 8-9 per cent. However in 1988 they ballooned to 13 per cent, reaching 16 per cent in 1989 and remaining above 10 per cent in 1990, even as it was becoming clear that there was trouble ahead. We all know what happened next.

Paper profits

It may be interesting to talk about cyclicality drivers and how they're related, but is there any practical application? In thinking about how players in this industry might improve their financial performance, it is helpful to look at other industries with similar characteristics. The paper industry, for example, is comparable in that it is capital intensive and cyclical.

One player in the paper industry has worked to understand the industry dynamics and use cyclicality to its advantage. Over the 15 years from 1980 to 1995, while the industry maintained only 13 per cent returns, Jefferson-Smurfit returned over 22 per cent annually to its shareholders. How? Largely by being on top of its industry's current position within the cycle and by making opportunistic moves to take advantage of that position.

For example, in 1986, when the industry was in the midst of a downturn and the future looked bleak, Jefferson-Smurfit took the opportunity to buy Container Corporation of America, a major acquisition. This was a risky move, but Smurfit structured the deal to reduce its exposure by initially taking a minority position (starting with only $60 million in cash) and securing options to increase its control in stages. The strategy paid off: within two years of the acquisition, paper prices were at an all-time high, and Smurfit's stock soared by 150 per cent.

In December 1989 Smurfit restructured its US operations, leaving it with a greatly reduced US position and releasing more than $1 billion in cash. Soon after, paper prices stumbled and a recession hit the global economy. But Smurfit was left with a horde of cash to fund further expansion in Europe.

Smurfit has shown a pattern of well timed acquisitions, internal expansions and divestitures. It has mastered the first two keys to managing cyclicality - one, understanding how key variables interact to drive the industry cycle and the current cycle status, and two using that information to make opportunistic moves.

Mastering cyclicality

The first step in mastering cyclicality is building the capability to understand in detail how the players and key variables - GDP, demand shocks, deliveries, retirements, costs, pricing and so on - interact to drive industry and company performance. This is very difficult to do well, since it involves quantifying a number of unknowns. But doing so can be extremely useful. Of course, this is not a forecasting tool. No one has yet found a crystal ball that can predict demand shocks like the Gulf war or the current Asian economic crisis. But an industry dynamics model can be used to develop discrete scenarios of what might happen, and determine what the impact would be.

Take the example of a large demand shock. If something like the Gulf war were to happen again and reduce demand for air travel by 5 per cent, what would that do to pricing levels and company profitability? In this case, how much capacity would the company like to have - in other words, how would capacity be adjusted if it were completely variable in the short term? The optimal level of capacity during the worst feasible industry outlook is the lower boundary of 'desired capacity'. The opposite extreme might be unabated economic expansion, presenting significant growth opportunities. How much capacity would the carrier like to have in this instance? This is the upper boundary of desired capacity.

While it is impossible to predict whether either of these situations will actually occur, framing the boundaries can provide guidance to airlines on the range of capacity levels they should be able to deliver. Ideally, an airline would have a continuously updated plan to hit either the low end of the range or the high end.

The limits of desired capacity will not always be the same distance from the current capacity level, depending on the position in the cycle. The model will estimate the current position in the cycle, using leading indicators - GDP, trade volume, orders - and their trajectory to help carriers 'see the turn' before the competition. This can help carriers time their growth initiatives to take advantage of the cycle rather than be victimised by it.

An industry dynamics model will serve as a platform to test growth and cycle management strategies. How valuable is an option to take delivery of additional aircraft versus their deferral? Or to change aircraft type? What if a carrier took a part of its fixed capacity and made it variable? What if the entire industry did the same? Knowing the impact of potential moves will let airlines know where to focus and let them experiment with alternatives they might not normally think of.

Opportunistic moves

With a clear perspective on industry dynamics, carriers can make opportunistic moves, leveraging their superior insight. Since a big part of making opportunistic moves involves hitting different levels of capacity based on the cycle, carriers will need to build flexible capacity that can be adjusted in the short term.

This will be challenging, since many capacity costs are fixed. Once aircraft are purchased or leased, crews and other staff hired and gates rented, those costs are typically in place for a long time. This effect reduces carriers' ability to make their capacity more responsive to demand. What would it take to make this 'fixed' capacity more flexible? Interestingly, core air travel demand (corrected for changes in yield) only deviates from medium term forecasts by +/-5 per cent or less. That means carriers can predict demand within a range of 10 per cent. Therefore, only 10 per cent of an airline's capacity needs to be flexible in order to match capacity to demand.

There are many things airlines can do to create flexible capacity. First, they can hire crews and acquire aircraft in smaller chunks over a longer ramp-up time so that they can accommodate downturns simply by bleeding off capacity through aircraft and personnel retirements. There is also potential to transfer capacity to products with more elastic demand, such as a low-cost concept. That way, marginal pricing approaches can be used while preserving the profitability of the core product. If demand exceeds forecast, carriers can postpone aircraft retirements and increase crew utilisation to create capacity.

With cooperation from labour groups, carriers can use short-term - 6 month - wet-leases to create flexible capacity. Since there is no existing business system to provide this type of lease product in sufficient quantity, carriers may need to work to encourage development of this capability.

Refurbished older aircraft can offer customers the comfort and safety of new aircraft without the high ownership costs. Consequently, even though older aircraft cost more to operate than new ones, they are particularly well suited to short-term leases. Crews, no doubt, will have job security concerns about the wet-lease concept, which will violate many scope clauses, but the long-term job security benefits and a limited maximum size of the wet-lease operation may be selling points for the concept.

Chart 3 lists possible opportunistic moves across the cycle. In upcycles, carriers can build their marginal capacity to reach the upper boundary of desired capacity. Upcycles may also be a good time to sell non strategic assets, such as route authorities that don't fit within the network, since prices will be at a high point. It may also make sense to develop creative financial vehicles such as future lease rights to parts of your fleet - again capturing the high value available in the upcycle.


In downcycles, capacity flexibility can be used to meet the reduced desired capacity, which may be approaching the lower limit. Aircraft retirements, lease returns and attrition are the main vehicles to make adjustments.

The downcycle is also the right time to prepare for the next upcycle. This may be the time to place orders for new aircraft (with deliveries appropriately spaced over time), or to acquire aircraft already ordered by other carriers or lessors which are now in a financial squeeze. Recent moves by many carriers to buy excess Asian aircraft are an example. While most carriers are likely to defer maintenance to save cash in a downcycle, it may make sense to accelerate maintenance to avoid having the fleet out of service for heavy checks during the next upturn.

Improving cycle management capability means increasing capacity responsiveness. The more responsive an airline is, the lower the severity of the cycles will be for it. Planning lead time, or the time required prior to departure date to commit to a flight, and capacity lead time, or the time required prior to need to request aircraft, must be reduced to make the system more responsive.

Along with the benefits, superior cycle management comes with risks as well. First, if a carrier is wrong about where it thinks the cycle is going, opportunistic moves may not look so opportunistic. And if a carrier restrains growth as others are adding - even if it is the right thing to do in the current cycle - there is a danger of losing market share and slipping down the S-curve. The key to managing both of these risks is maintaining capacity flexibility. No one has a crystal ball to predict exactly what is going to happen and potential scenarios must be anticipated and planned for.

Pursuing a long-term, cycle management strategy requires strong support from investors and employees alike. Retaining the necessary cash to make opportunistic moves, as well as making specific moves like acquisitions or large aircraft orders during downturns, requires an investor group that understands and supports the long-term strategy, and has confidence in the management team's ability to carry it out successfully.

The long-term job security benefits of capacity flexibility strategies such as short-term wet leases must be understood and agreed to by labour groups, which will naturally feel threatened when first exposed to this concept. All this points to the need for a proactive internal and external communication plan, backed by consistent actions and success.

Influencing the industry

While there are significant benefits from managing the cycle better than competitors, an additional payoff will come when the industry as a whole does a better job of matching capacity to demand. The third step in mastering cyclicality is reaching beyond actions that benefit only the individual carrier to take action that benefit the carrier and the industry as a whole - of course, this must be done in compliance with the relevant antitrust regulations. The recent wave of broad global alliances such as the Star Alliance will create new opportunities to share insights and take actions with greater industry impact, like shifting capacity from low demand regions to high demand regions.

There may be times when it makes sense to share projections outside alliances as well. For example, if one carrier knows a downturn is coming, and other carriers in the market are considering placing new orders or confirming options, a compelling case pointing to an industry downturn could prevent some of those orders and reduce the severity of the downturn.

The entire industry would benefit if each player made its capacity more responsive. So if one carrier develops a method to make part of its capacity more flexible, that may be worth sharing as well.

Growth without profitability will not be acceptable to today's increasingly sophisticated and active investors. Airlines can grow profitably in their core business if they do so in a way that addresses the structural drivers of poor profitability. This means first, knowing what the drivers of industry performance are, how they relate to each other, and where a carrier is in the cycle; second, influencing the drivers of profitability to one's own benefit; and third, where it makes sense, influencing the industry for the benefit of every player in it.

Source: Airline Business