TSM09913 Global Airline Industry

Lecture 10: Understanding Airline

Profitability (or lack of)

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Aim of this lecture/tutorial

• To gain an understanding of airline profitability

• Understand why airlines find it hard to be
profitable
• Identify which airlines have created shareholder
value
• Examine what drives the industry’s poor financial
returns (Porter’s 5 forces analysis)
• Consider why the Low Cost carrier (LCC) model
has fared slightly better against these forces
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Financing airlines

Equity
• a wide range of investors (shares
on stock market).
• Airline shares are highly volatile
and tend to attract short-term
oriented traders.
Debt
• mainly provided by banks (often
specialised airline financing divisions)
• Direct purchasing of aircraft is often
through loans
• Aircraft can also be leased, which
keeps airline loans off the balance
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sheet.
Investor’s capital in airlines
(IATA, 2011)

$500bn investor’s capital tied up in airlines

Equity and debt cost averages 7-8% in airline industry

8% of $500bn = $40bn in annual returns to keep that capital invested

in the industry

Over the past decade investors in airlines have seen their capital earn
$20bn LESS than it would have earned elsewhere

On average during 2002-2009 cycles the industry destroyed $19bn of

shareholder capital each year

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No single ‘magic ingredient’
Industry
Average

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Profitable Airlines

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The top 4 most profitable
airlines during the 2000’s

Cost leadership – Slot and route Geographical

Low tax regime can undercut any rights position S-N flows
Low fuel costs competitor Serving a large 50% of pax route
Buying planes and fast growing through hub
Economy of
post 9/11 market
scale Has 25-30 gates
Low airport costs Benefits from available at peak
Geographic airspace access
position at secondary times
airports revenues
Dominant route
rights

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Task 1: Using Porter’s 5 forces as a
template, discuss:

What is the level of threat each factor has for

the airline industry (e.g. small, medium,
high?) and itemise the types of threats to
the airline industry of each factor:
• Bargaining Power of Suppliers
• Threats of New Entrants
• Bargaining power of Buyers / Channels of Distribution
• Threat of Substitute products and services
• Rivalry within the industry
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Task 2: Using the framework again:

Have LCC generally fared better

over the past decade against these
driving forces?

Why might this be?

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Determinants of airline industry
profitability - Porter’s 5 Forces

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Force 1:

THE BARGAINING POWER OF

SUPPLIERS
IS HIGH

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1. Bargaining Power of Suppliers

Unions be very strong,

Labour Airlines are very
dependent on high
and each group
negotiate separately but

/unions skilled employees

have power to cripple
an airline (pilots,
baggage handlers)

Aircraft and Many associated cost

risks have been shifted
engine Oligopoly of both
suppliers with high costs
to airlines – aggressive
competition led to low
producers barriers of entry

Servicing 30-50% of servicing Outsourced services

and provided by external
suppliers,
mean less in-house
control
maintenance
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Airline Staffing

Aviation is a highly labour-intensive industry

94% of workforce made up of Pilots, flight attendants, mechanics and

other aircraft and traffic- servicing personnel

Comparatively highly trained and skilled labour force (compared to other

industries)

Airlines have a 24/7/365 operation, which requires a lot of displacement

of staff around countries and around the world

Wages are expected to reflect the degree of complexity and

responsibility of the job

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The Unionisation of Airlines

Highly unionised labour force – especially legacy airlines

There is no single union representing the entire workforce – eg pilots, flight

attendants, baggage handlers, air traffic control – all have their own unions

Strike in one area can halt production in all areas – perishable product
cannot be stockpiled or stored

Makes airlines highly vulnerable to strikes and gives workforce a strong

bargaining position

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1. Bargaining Power of Suppliers (2)

Many airports are Many large hubs

local monopolies with charge very high fees
Airports limited competition
from nearby
– and it can be difficult
to switch if that is a
secondary airports major hub

Many associated cost

Jet fuel Been steadily rising
risks have been
shifted to airlines –
suppliers over the past decade aggressive
competition led to low
barriers of entry

Government- Such as costs of air

Imposed taxes like
APD, environmental
mandated traffic control through
air taxes or airspace
taxes and airport
levies add to airline
services costs
costs

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 Jet Fuel Price high but holding
steady (as at 07 March 2014)

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Source: IATA.org
Fuel Prices estimates for 2014 at 07 March 2014

Jet fuel Index* US$/ Cents/ 1 week 1 month 1 year

price at: barrel gallon ago ago ago
07 Mar 14 337.3 123.4 293.0 -0.6% 0.9% -3.5%

* 100 in 2000 (87 cts/gal)

Impact on this year's fuel bill of the global airline industry:

New fuel price Impact on 2014

average for 2014 Fuel Bill
$124.2/b -$4.8 billion

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Source: IATA .org
Capital investment

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Returns in the supply chain

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Returns are not related to risk

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Force 2:

THE THREAT OF NEW

ENTRANTS
IS HIGH

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2. Threat of New Entrants

Fewer barriers to entrance

• Easy finance
• Access to distribution channels easier – no longer controlled by incumbents
• Existing airlines can easily expand into new markets

Market opened up to new entrants through

• Removal of ASAs and deregulation
• Introduction of cabotage in EU
• Open Skies between US-EU

Over 1300 new airlines have been set up in the past 40 years

30 per year enter but less than 1% depart in a year

• increasing competition

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Entrants to market continue to
grow despite low profitability

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Force 3:

THE BARGAINING POWER OF

BUYERS
IS HIGH

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3. Bargaining Power of Buyers

A significant share of end consumers (particularly

leisure) are highly price sensitive

The transparency of pricing has been opened by the

internet

This has handed the ability to search for bargains

and availability directly to consumers

Loyalty to specific airlines is low apart from a few

frequent flyers
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Force 4:

THE BARGAINING POWER OF

CHANNELS
IS HIGH

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4. Bargaining Power of Channels
of Distribution

Aggregator websites
• Concentrated consumer’s buying power – increase transparency of prices
• GDSs have made it very easy for new aggregator websites to enter the market

Travel agents
• Very strong especially in corporate market
• Have significant power to shift demand across carriers (incentives)

Business Customers
• Loyalty programmes raise switching costs
• Alliances are creating switching costs

Leisure Customers
• Choice based almost entirely on price
• Transparent pricing structure creates incentive to search for ‘a better price’

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Force 5:

THE THREAT OF SUBSTITUTES

IS MEDIUM & RISING

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5. Threat of substitutes - is
Medium and Rising

The most powerful substitute is not to travel

• Better technology (skype, conference calls etc) gives an
increasing number of alternatives to travelling at all
• Airline industry very reactive to external forces such as
weather, wars, pandemics, etc etc
Alternative forms of transport
• High speed trains increasingly threaten short haul flights and
particularly LCC for city to city
• Burden from security in airline check-in has increased
journey time making alternatives faster over short haul
distances
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Threats to demand: Vulnerable
to External ‘Shocks’:

Wars

Terrorist
attacks
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Threats to demand: Pandemic
Health Scares

SARS 2003

Bird Flu 2004

Swine flu(H1N1) 2009

….???? Flickr Creative Commons by Guerry

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 Snow

http://www.reuters.com/resources/r/? 32
m=02&d=20101231&t=2&i=291589449&w=460&fh=&fw=&ll=&pl=&r=2010-12-
31T091945Z_01_ALNE6BU0PXG00_RTROPTP_0_USA-WEATHER
Earthquake/Tsunami 2011

Earthquake in Japan in March

2011 initiated a tsunami and
nuclear incident

Tsunami destroyed Haneda

airport

Service in/out of area was

compromised for several
months
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http://www.youngdemsbarbados.com/?p=99
Iceland’s Eyjafjallajokull volcano
mid-April 2010

Plume covered much of Europe for 7

days

100,000 flights cancelled

1.2 million passengers affected

Total impact on airline revenues =

US$418 million PER DAY

Total = US$1.7bn losses

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 High speed rail

http://www.dailymail.co.uk/news/article- 35
465849/High-speed-rail-network-challenge-low-
cost-flights-Europe.html
Force:

RIVALRY BETWEEN EXISTING

COMPETITORS
IS HIGH

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Rivalry within the industry

Rivalry in the industry is intense

At its core is the excess capacity that drives down prices

and slashes profits
• Aircraft capacity is affected by long lead times for fleet orders
• Bulk buying aircraft gives higher rebates
• Operating larger planes reduces marginal fares
• Governments have a tradition of bailing out airlines

All this leads to excess capacity and reduced margins

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Other factors affecting rivalry
within the Industry

Highly perishable product

Similar products that are hard to differentiate

Marginal cost structure – high fixed costs

Uneven playing field between policy regimes in different states – affects

competitive interaction

Over time labour costs rise and pressure to grow forces airlines to
increase operation complexity

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Five forces in the airline industry

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Some suggested answers to why
LCC airlines have done better

Fewer barriers to exit

• Non legacy carriers so ailing airlines have exited the market
• Has led to more sustainable profit rates

Low cost airlines face weaker suppliers

• Lack of unionisation
• Secondary airports give lower or no airport charges

Point-to-point business model advantages

• Creates a distinct value proposition – low prices rather than having lots of products for different
customer groups
• They don’t face aggressive price–setting rivalry
Better market structure
• Their shorter history has allowed new entrants to avoid the high costs of many legacy carriers
• LCC make more money from ancillary services than from ticket sales

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Summary

Airlines face threats from many directions:

in their supply chain; from suppliers, customers, new

entrants, substitutes and competitive rivalry
The industry structure and competitive environment has
led to low margins and lost value
The LCC model has managed to avoid some of the main
problems
However, as this market reaches maturity, this
competitive edge appears to be reducing

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References

• IATA (2014) Jet Fuel Price Monitor - This week's price of aviation fuel
[Online] Available at:
http://www.iata.org/whatwedo/economics/fuel_monitor/index.htm
[Accessed 24 March 2014]
• IATA (2012) Vision 2050 Singapore 12 February 2011 [Online] Available
at: http://www.iata.org/pressroom/facts_figures/Documents/vision-
2050.pdf [Accessed 20 March 2013]

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