ANDREW SENTENCE BRITISH AIRWAYS LONDON
Passenger traffic has historically grown much faster than the underlying economy, but there is evidence that as markets mature, the airline industry may have to rein back its expectations.
Over the past couple of years, the global airline industry has recorded some impressive growth figures, supporting the popular view that we are a fast-moving, dynamic sector of the global economy. Latest data suggests that international passenger numbers rose by 9% last year and 8% the year before that. Admittedly those figures are flattered by the economic recovery in Asia, but taking a longer term view, airline growth rates still look strong. Over the last two decades, international passenger numbers averaged annual growth of 6% while overall traffic in terms of revenue passenger kilometres (RPKs) rose faster still at 7%.
Even if slower-growing domestic markets, in particular the mature USA, are included in the equation, world traffic growth still exceeds 5% per annum. It is not surprising, then, that many international airlines have come to regard such growth rates as the norm - roughly double the rate of economic growth in the major industrialised economies. Yet this view of the world is potentially highly misleading as a basis for airline planning and strategy.
As an estimate of the "natural" growth of the market, 5-6% is too high - and it is likely to create a bias towards over-investment in capacity, perpetuating the poor profitability of the airline industry. There are four main planks supporting this argument:
Airline traffic growth over the last two decades has been heavily stimulated by real yield declines. Sustainable yield reductions depend on the ability of management to drive down unit costs and some of the factors supporting past cost reductions appear less favourable in the future; Network and frequency expansion has also supported strong aviation growth. Where new destinations and services are not being added, the prospects for profitable growth will be much weaker. Network expansion also adds cost, which must be covered by the extra revenue generated by new routes and extra frequencies; Real revenue growth, which is a better measure of the extra value which airlines can generate in the marketplace, grows roughly in line with economic activity (GDP) across the world economy - rather than as a multiple of the economic growth rate; As the world's most mature aviation market, the US domestic sector indicates the shape of things to come. Real revenue is growing significantly below GDP, while airlines have maintained profitability through consolidation and cautious capacity planning. We should expect this pattern to be followed in Europe, as airlines adjust to more liberal markets.Yield declines
In real terms, airline yields have fallen dramatically over the last three decades. Since 1970, the real yield per RPK for scheduled airlines across the world has more than halved in value - a rate of reduction of around 2.5% per annum. Developments in technology and efficiency improvements have allowed airlines to reduce the cost of air travel, which in turn has stimulated demand. Without matching reductions in unit costs, lower air fares would not be sustainable.
Three main factors have underpinned these cost and yield declines. First, there have been improvements in aircraft technology through lighter materials, more efficient engines and electronic management systems. Second, oil prices have fallen back in real terms from the record levels of the late 1970s and early 1980s when the cost of a barrel of oil peaked at around $80 at today's prices. By the late 1990s, the price had fallen by around 75%. Much of the benefit has been passed on to the consumer in the form of lower fares, though some of the gains have been eroded by recent oil price hikes.
Third, market deregulation has led to improvements in airline efficiency as the major network carriers respond to increased competition and new low-cost entrants. In the US domestic market, it is estimated that deregulation cut fares by over a fifth in the 1980s. A similar downward pressure on yields, in conjunction with improved efficiency, should also be seen within Europe as its markets make a similar transition.
It is important, however, to be careful when extrapolating these cost reductions into the future - particularly if they are the product of one-off step changes, such as a fall in the oil price or a boost to efficiency from market deregulation. Over time, efficiency programmes are likely to yield diminishing returns as they move closer to competitive cost levels and the industry adopts best practice. There may be other step changes in cost to come in the future - such as a reduction in distribution costs as airline tickets are sold increasingly on the internet and the volume of e-ticketing increases. However, in other areas, costs may rise - for example due to increasing congestion and environmental charges. Future developments in aircraft technology are also likely to be targeted at meeting higher environmental standards for noise and emissions rather than lowering cost. Taking all these factors into account, it is likely to become harder for airlines to realise the cost and yield reductions they have achieved in the past. The boost provided to airline growth from lower yields is also likely to tail off.
Network and frequency expansion
The falling cost of travel is just one reason why air traffic tends to grow faster than the economy as a whole. Its effect is probably greatest in leisure markets, where travellers tend to be more price-elastic. Boeing, among others, cites two additional factors which are causing the growth of air travel to outpace GDP growth: globalisation of business activity, which stimulates cross-border trade and investment, and the expansion of airline networks.
For airlines, globalisation is something of a double-edged sword. It may stimulate the volume of business travel, but it also intensifies the pressure on corporates to reduce the cost of travel as competition grows. Trends in trade volume and prices show this very clearly. The volume of world trade has been growing nearly three times the rate of world economic growth in the last decade, but the price of traded goods and services have been driven down relative to the price of activities sheltered from world trade. This downward pressure on prices is transmitted into the purchasing decisions of global companies. They squeeze every element of cost, including travel budgets. And it is now easier to trim travel without hampering business prospects thanks to the growth of telecommunications networks, the Internet and teleconferencing.
The expansion of airline networks is, however, clearly an important driver for growth. Boeing calculates that the route network operated by scheduled airlines has nearly doubled since 1985, increasing at around 4.5% per year. This expansion accounts for the bulk of airline capacity over the last decade-and-a-half, with the number of passengers travelling per km of route network growing at just over 1% a year. The expansion of the route network allows passengers to travel when and where they want more readily and this improvement in service quality is a major driver of air travel. In more liberal markets, with more competition, the trend is towards the operation of more frequent services with smaller aircraft to attract lucrative business traffic - except at the most congested airports. Airlines should make very cautious assumptions about the amount of profitable growth they can expect in markets where they are not adding new destinations and new frequencies.
Airlines also need to recognise that network expansion involves extra cost - more aircraft, more staff and more support services. In that sense, the growth that is induced by network expansion has a parallel with that stimulated through a decline in yields. In both cases the growth is being "bought" at the expense of the bottom line. Airlines need to ensure that the value of new business more than compensates for the extra cost of securing it. The generally poor record of profitability across the airline industry suggests that this has often not been the case.
Real revenue rises
How do we measure the increased value that travellers place on the services which airlines provide? Rather than the growth in passenger traffic, a better measure is the rise in real revenues which the industry generates (ie revenues deflated by a general measure of inflation, such as the consumer price index). This removes any impact of the decline in real yields from the growth calculation. The result is a very different picture of aviation growth compared with the buoyancy suggested by traffic growth trends.
Airline revenues have risen by 3% a year in real terms since 1980. Instead of increasing at a multiple of economic growth, this is actually slightly behind the growth rate of world GDP; real revenues are growing roughly on par with the economy. For business travel, this picture is not so surprising. The real value-added generated by the corporate sector will rise roughly in line with GDP and companies will be reluctant to allow their travel budgets to expand in relation to this total, keeping the two growth rates roughly in line.
However, while spending on business travel is likely to rise in line with the economy as a whole, why should that also be true of leisure markets? The conventional wisdom is that tourism spending is highly income elastic, and that leisure passengers will therefore want to spend an increasing proportion of their rising incomes on travelling to ever more far-flung and exotic locations.
The answer to this apparent paradox is that airlines are not particularly well placed to extract their full share from the holiday value chain. Tourists often want to conserve their cash until they get to their destination, rather than spend a lot of money on the journey. In addition, the competitive nature of the international airline business - with many discounted tickets available and tour operators able to drive hard bargains with airlines - allows the leisure traveller to cut costs on this component.
Market maturity
Real revenue growth for the airline business may average 3% across the global economy, but it is falling significantly below the economic growth rate in the most mature markets. In the 1980s, real revenue growth from the US domestic market was one percentage point below the economic growth rate. By the 1990s, airline revenues were growing at just over half the rate of US GDP (see bottom chart). Though there was still some stimulus from falling real yields, air traffic barely grew faster than GDP. What is more, a significant proportion of this growth was accounted for by the new breed of low-cost operators such as Southwest. In the 1990s, the established network airlines saw their real revenues from the US domestic market grow at around 1% a year.
This pattern of market maturity is likely to emerge in other regions once the "growth spurt" generated by deregulation and new "low-cost" competition subsides. With access to relatively cheap air travel, neither leisure nor business travellers are keen to devote more of their budgets to air travel. At the same time, industry consolidation means that network expansion no longer provides a major stimulus to growth. As Europe moves through the deregulation phase the industry should expect a similar pattern to emerge of maturity and low growth. Mature markets are unlikely to grow at much more than 3% a year - and the real revenue growth from these markets may be lower still.
Economies which are genuinely dynamic, such as the Asian tigers and many "emerging" markets, will exhibit stronger growth as they rapidly develop. But airlines based in North America and Europe may not be well-placed to tap this rapid growth. As global aviation markets liberalise more broadly and the industry consolidates, we should expect the lower-growth US domestic experience to become the norm rather than the exception.
Strategic implications
So what are the underlying implications of this analysis for airline planning and strategic thinking? Three general conclusions stand out. The first key point is that as markets move into this more mature phase, airlines need to think in terms of much lower growth rates than historic norms to underpin capacity expansion and planning. If sustainable cost reductions become harder to achieve and real revenue growth falls below that of GDP, it will not be profitable to sustain capacity growth rates of 5-6%. The experience of the past couple of years provides something of a warning here. Despite the strong bounce-back in the global economy, airline profitability has stubbornly declined. Higher oil prices have been part of the story, but so have falling yields, as airlines have sought to fill the excess capacity - which continues to grow at 5-6%.
Second, the adjustment to a more mature market is likely to require some industry consolidation and rationalisation. It is no coincidence that the US major network airlines only began to achieve profitable growth in the 1990s once the industry had consolidated and capacity growth had been reined back. European consolidation looks to be the next big step, as the region makes the transition to more mature market conditions in the wake of liberalisation.
Finally, individual airlines need to link their growth strategies to both their cost position and opportunities for network expansion, different circumstances dictating different strategies. Established network airlines are less well-placed to price themselves aggressively into new markets than the more agile, flexible and low-cost "no-frills" airlines - and need to adjust their growth aspirations accordingly.
For British Airways, in particular, the opportunities for profitable network expansion are also limited by the severe constraints at our major London Heathrow hub. The need to adjust to this situation - and the increased competition generated by the development of competitor hubs in continental Europe - underpins BA's programme of cutting capacity by reducing average aircraft size. These pressures on our London-based airline network will only be eased by the development of new airport infrastructure which might eventually help to restore Heathrow's competitiveness as an international aviation hub.
About the author
Dr Andrew Sentance is chief economist at British Airways. He joined the airline in 1998 from the London Business School where he was director of the Centre for Economic Forecasting. He had previously been director of economic affairs at the Confederation of British Industry (CBI).Dr Sentance is a graduate of Clare College, Cambridge, and went on to gain his doctorate at the London School of Economics. He was also one of the panel of seven "wise men" which provided economic forecasting advice to the UK Chancellor of the Exchequer under the last Conservative government.
Source: Airline Business
