3D Insight - AACO Insight - AACO - Seabury Quarterly... · 3D Insight A Publication by AACO and Seabury Aviation & Aerospace ISSUE 02 – VOLUME 01 May 2009. Inter-Airline Cooperation

3D Insight A Publication by AACO and Seabury Aviation & Aerospace

ISSUE 02 – VOLUME 01May 2009

Inter-Airline Cooperation

01

The original article used the metaphor of severalshepherds sharing a piece of land. It is in thebest interest of each individual to graze as manyanimals as possible on the land; however, ifeveryone makes this decision, the land will bedestroyed and all herds will suffer. Similarly,the independent behaviors of multiple airlinesoperating in the same market are likely to resultin the development of predatory behaviorsthat erode the total market value. The barriersto entry and growth in aviation are relativelylow, constantly creating more “shepherds” tocompete in a set “pasture.” At the same time,there are high barriers to a natural exit.

Fortunately there are cooperative solutionsto these challenges, each characterized bydifferent levels of risk and return determinedby the degree of harmonization and integrationamong the participants. The solutions, whichinclude interline agreements, code shares,alliances and mergers and acquisitions, havemany strategic advantages over a unilateralapproach; however, participation is contingentupon other carriers and stakeholders agreeingto cooperate. Agreement of participants isnever guaranteed, particularly when regulatorybodies and governments are involved, and assuch the opportunity to pursue each initiativeis not always present. Carriers must thereforedetermine the opportunities available to themand pursue those which offer the greatest value.

The industry is rife with destructive competitive

behaviors. Fleet expansion (larger herds) andprice wars are all too common. These behaviorsare fueled by other market participants –governments, OEMs, airports – that have avested interest in capacity growth. Acting inone’s own self interest can yield benefits ifcompetitors exit the market, but if the majorityof players remain – or if a continual influx ofnew competitors and new capacity enter themarket – the available value for all participantsis eroded. Several initiatives can be pursued toreturn value, but they require a paradigm shiftfrom competitive to cooperative relationshipswith other carriers.

Aviation executives have been calling forcooperation and consolidation as a solution tothe myriad of problems facing the industry. Inthe current environment these discussions arebeing approached with new vigor. The promiseof consolidation is higher returns and decreasedrisk through the establishment of a dominantentity with control of capacity, pricing powerand economies of scale. Despite the attentionthat mergers and acquisition (M&A) transactionsreceive from the media and financial analysts,the reality is that there are many barriers tothese activities (see table 1). For these reasons,successful M&A transactions are challenging,with most full consolidation attempts failingto deliver perceived value or abandoned priorto integration (see table 2). Executives shouldremember that while airline M&A transactionsare able to unlock great benefits, they also

The “tragedy of the commons” metaphor resonates strongly inmodern commercial aviation. In Garret Hardin’s 1968 Sciencepublication he describes a dilemma in which multiple individualsacting independently can ultimately destroy a shared limitedresource even where it is clear that it is not in anyone’s long-terminterest for this to happen.

Article

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ISSUE 02 – VOLUME 01 3

Tab 1 - Barriers to Consolidation

Tab 2 - Recent M&A transactions

Risk

carry the greatest risk of any cooperativeactivity. Several lower-risk opportunities cannet a material portion of consolidation benefitswithout the complexity, risks and regulatoryhurdles of full merger.

The risk averse options sit under the umbrella of“inter-airline cooperation.” These looser formsof cooperation have the additional benefit ofallowing for multiple partnerships to be forgedcreating a diverse portfolio of cooperation. Theterm encompasses interline partnerships, codesharing and strategic alliances. As the levelof cooperation and degree of harmonizationescalate, so too does the relative value capture(see figure 1). The barriers and risks associatedwith M&A, particularly cross-border M&A, areoften so large that this option is preferable in

only a limited number of scenarios. Inter-airlinecooperation strategies can provide competitiveadvantage with less integration complexity andrisk.

Interline agreements allow an airline to sellanother carrier’s flight under one ticket. Theseticketing arrangements provide revenue uplift asthe participants are able to collect revenue on ajoint itinerary where it may have otherwise beenlost. Further benefits may be achieved throughincreased customer satisfaction. If separateindividual segments are purchased, the customeris exposed to delays, cancellations andthe hassle of collecting luggage and re-checkingit at the point of transfer. By purchasing a singleitinerary, consumers gain confidence associatedwith knowing they will not be stranded and

forced to repurchase a ticket if operationaldisruption occurs.

The next step to increasing cooperation iscode sharing. Under a code share agreement,multiple airlines may market the same flightunder different codes. In these arrangements,the airline operating the flight is termed the“operating airline” while those marketing it usingtheir own codes are termed the “marketingairlines.” Operating carriers and marketingcarriers must have interline agreements withall other carriers on an itinerary to allow singletickets to be issued. There is an increaseddegree of cooperation among carriers thatgoes beyond the superficial manifestation ofmultiple codes associated with a single flight.Carriers will frequently synchronize schedules tooptimize transfer time and facilitate coordinationof baggage transfer. The marketing airline gainsan extended network and the perception ofcity presence in an un-served or underservedmarket, without requiring the dedicationof a hull. Code shares can be particularlyadvantageous as a means of eliminating theproblems associated with the “tragedy ofthe commons.” Excessive competition andovercapacity on thin routes - a primary driver ofyield deterioration - can be eliminated throughwell-structured code shares. Both carriers canretain network/city presence while at the sametime freeing capacity that can be redeployed tofurther strengthen the rest of their network.

In addition to the marketing, network andoperational benefits of code sharing, greatvalue is derived from improved positioning inbooking systems. Itinerary search engines give preference to direct flights, followed by layover

flights with a single flight number, then flightswith multiple airlines under one ticket (interline)and finally flights with multiple carriers requiringsegments to be purchased separately. Codesharing gives the perception that the itineraryis operated by one carrier under a single flightnumber, improving the position of the itineraryand increasing the likelihood of purchase bythe customer or booking agent. Purchasingbehavior may be further influenced by allowingcustomers to earn points through the frequentflyer program of the marketing airline.

Just as code shares evolved from increasingcooperation beyond that associated withinterline agreements, strategic alliances leveragea further degree of harmonization amongparticipants to capture greater value. It is clearthat alliances are expanding their global breadth(see figures 2 and 3). Since 2000, the number ofcarriers participating in the major global allianceshas grown from 26 to 68, with capture of globalavailable seat kilometers (ASKs) rising from 43%to 58%. Participation in these alliancesis attractive for many carriers as membershipholds the promise of revenue enhancement,cost reduction and improved customer satisfaction.The primary drivers of these benefitsinclude revenue uplift through network and FFPharmonization and cost-rationalization throughsales and marketing, maintenance, facilities,labor and purchasing improvements. Participationin an alliance is dependent upon invitation.Alliances make invitation decisions based onscale, traffic flows, ability to integrate IT systems,capture of premium traffic and the abilityto enhance, rather than threaten, the position ofdominant members in the alliance.

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Fig 1 - Forms of consolidation. Carriers can, and do, achieve a material portion of the benefits of consolidation without the complexity, risks and regulatory hurdles of full merger.

Source: Seabury analysis, alliance websites

Fig 2 - Global Alliance membership since 2000

Fig 3 - Global Alliance membership since 2009


Source: Seabury analysis, alliance websites

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AACO members have another alternative:Arabesk, a regional non-binding alliance.Arabesk is a regional network alignmentinitiative designed and championed by AACOexclusively for AACO members. Participantsderive value through reduced duplication ofcapacity, linked networks and destinations,improved customer connectivity and maximizedcapacity utilization through route sharing andrationalization. This cooperation overcomesmany of the market hurdles described by the‘tragedy of the commons’ and ultimately fostersthe successful growth and profitability of Arabcarriers.

The chronic problems of the airline industryare rooted in margin destroying relentlessgrowth (“tragedy of the commons”) and thejuxtaposition of highly cyclical demand withrelatively fixed capacity and costs. Industryconsolidation is seen as part of the solutionto these problems. Regulatory and politicalbarriers make true consolidation slow, withmost transactions abandoned or failing todeliver value. Cooperation, rather than M&Aconsolidation, among carriers continues tooffer opportunities to capture value at reducedlevels of risk. These opportunities should be animportant component of any long term growthstrategy.

Arab carriers have low representation in themajor international alliances, primarily due to theperception that many of the carriers pose a threatto Europe-Asia Pacific traffic flows. Majors in bothregions (eg British Airways, Cathay Pacific, JapanAirlines and Qantas in oneworld, Lufthansa,Singapore, Thai and Air China in Star Alliance orAF-KLM, Korean and China Southern in SkyTeam)would likely feel vulnerable at the introduction of amajor Arab carrier to their alliance. Because majorArab carriers operate parallel routes connectingEuropean and Asian hubs, they may be viewedas a challenge, rather than enhancement, to theposition of the dominant members.

02Article

Cost, Liquidity & External Cooperation: Contract renegotiation, joint purchasing programs and outsourcing with vendors/MROs/other airlines

Airlines are able to unlock significant inventoryand supply chain benefits, both in terms ofthe balance sheet and the P&L, by increasingcooperation with external entities. Erodingyields, reduced passenger numbers anddifficult credit market conditions have putsignificant strain on virtually all carriers. In aneffort to limit losses or sustain profitability,carriers have employed a variety of strategies:eliminating flights, reducing staff, groundingaircraft, accelerating fleet retirement andseeking capital injections from governments/investors. Pursuing these initiatives is difficultas the effect on employee morale and/orcustomer satisfaction can be significant. Asan alternative to these approaches, executivesshould be conscious of opportunities affordedthrough creatively designed – or thoughtfullyrestructured – vendor contracts. Theseinitiatives, which include restructured paymentterms, contract duration, defragmentation ofsupplier portfolio, joint purchasing programsand outsourcing strategies, drive benefits byre-allocating risk and capital to where they canbe managed more efficiently: at the supplierlevel. The suppliers’ scale and specializationposition them to reduce a carrier’s inventorymanagement and financing costs, making

restructured supplier agreements effectivemeans of driving liquidity and profitabilityimprovements.

Extension of payment terms represents thesimplest vendor cooperation strategy thatcan yield short-term liquidity improvements.Liquidity is improved by delaying theremuneration of debts. Although this stabilizesthe balance sheet in the short term, theseinitiatives may have unintended consequences.For example, suppliers may require largerminimum purchases and/or demand higher unitprices as a trade-off for providing extendedcredit terms. A more sustainable approach is tonegotiate better contract terms by exchangingcontract length for decreased unit costs.Suppliers may be willing to accept smallermargins as a substitute for the security oflocking-in a long-term revenue stream.

A more holistic approach that extracts valuefrom increased cooperation with suppliersis the consolidation of repair contracts. Theprocurement portfolio of most airlines ischaracterized by a large number ofspecialized suppliers.


The size and fragmentation of this network drivesmanagement complexity into the procurementorganization. Inviting competing suppliersto vie for an entire maintenance portfolio cancreate substantial revenue uplift for the winningsupplier and cost reduction for the airline. Essentially, an executive can create scale withinhis/her organization by combining elementsthat were previously tendered on individualagreements. The fact that different contractsbear different terms makes the transaction allthe more attractive to consolidators because thewinning vendor can transition repairs into its ownshop as old contracts expire. The airline benefitsfrom decreased costs and a reduced number ofsuppliers/contracts.

Creating scale through joint purchasingprograms with other carriers can also bea powerful tool when negotiating vendorcontracts. Alliances have tried to leverage theirscale in procurement of aircraft, maintenanceservices and commodities, such as fuel. AACOrecognized this value, orchestrating reductionsin fuel procurement costs and distributioncharges by leveraging the scale of the groupto achieve price concessions. However, somepooling strategies have failed as a result of thecomplexity of managing the interests of so manyentities. For instance, Star Alliance attemptedto pursue an agreement on aircraft commonalityfrom its membership. In addition to increasingbargaining power with aircraft manufacturers,it hoped to improve operational flexibility byenabling carriers to swap delivery slots ordry lease aircraft to each other. These effortseventually fell short of expectations due to thevast differences among the members.

Alliance carriers are characterized more oftenby differences than similarities. They operate awide range of fleet types, have varying degreesof balance sheet strength, and, most importantfrom an integration perspective, have significantcultural differences. The pursuit of a StarAlliance procurement strategy failed in large partdue to these hurdles, despite strength in theunderlying principles. Shared language and acommon pan-Arab culture may better positionAACO members to overcome some of thesedifficulties.

The most advanced form of airline-suppliercoordination is an outsourcing strategy. Theseagreements go beyond the benefits of improving

parts inventory and allow for the ability to sellcapital assets as well as exit facilities leases.Furthermore, an outsourcing strategy mayallow for the consolidation of multiple airlines’volumes, further driving down the unit costs forthe entire consortium of participants. Underthe terms of an outsourcing agreement, thecarrier relies completely on the capabilities ofthe outsource provider. Many carriers chooseto outsource spares (eg engines, rotablesor expendables) to leaseback, pooling orconsignment programs. Historically, airlines havepreferred to hold these assets close, keepingtens if not hundreds of millions of dollarsworth of spares on hand. The advantages oftransferring spares management to a reliablesupplier are exhibited by the most nimble,new-generation carriers. These include a largecash influx at sale, with better than marketprices often achieved by appending repair orprocurement agreements.

A final element of close collaborationbetween airlines and suppliers is risk-sharing.Arrangements that transfer and align supplychain and financial risks outside of the carrier’sorganization are increasingly common. Forinstance, nearly half of engine maintenanceagreements are structured on a cost-per-hourbasis. Similarly, larger MROs offer end-to-endpower-by-the-hour agreements that transfer alarge part of the risk to the supplier.

Closer cooperation with vendors offerssignificant, and often untapped, near-termliquidity and long-term cost opportunities forcarriers. These opportunities are also likely toimprove a carrier’s ability to access vendorfinancing as one can trade P&L for liquiditywith the vendors. In addition to financingbenefits, these cooperative strategies alsocircumvent many of the industrial and publicrelations hurdles that stymie so many labor andcost-reduction strategies. For each of theseapproaches, carriers must fully understand theircost drivers to enable judgment of the long-termfinancial implications that closer collaborationwith industry partners can bring. The volatilityof 2008 has changed the aviation landscape,and it is prudent for executives to explore newstrategies that shore up weakened balancesheets and bolster waning profitability. Vendorcontract restructuring can be a valuable tool forexecutives to wield as they endeavor to restorethe financial health of their airlines.

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03Breaking Down Barriers

03Article

Increased collaboration can positively impact your bottom line

Airline Executives have the responsibility of defining andimplementing sound strategy for company growth. The dailyresponsibilities of this role include communicating with the Boardand other stakeholders, managing operational issues, addressingregulatory concerns, and ensuring that compliance requirementsare met. Additionally, there is the responsibility to provide counselto internal leaders to help them achieve departmental goals, aspart of the company’s overall strategic focus.

Within any airline, there are natural tensionsand exchanges that can cause stressand create inefficiency. Boundaries existbecause of conflicting goals, strategies,measurements, structural differences,location and proximity of personnel,and general misalignment on priorities.

One example is the conflict that can developin the relationship between gate agentsfocused on providing excellent customerservice by allowing the last “late” passengerto board and the operations staff and crewwhose objective is to depart on time.

In the case of aircraft utilization andmaintenance control personnel, one group isinterested in conducting a careful series ofcomplex tasks, persistently checking for theslightest change in detail, while the other’sgoal is to get the aircraft out on time.

In order to lead and grow the business,executives must ensure that teamsand individuals work well together andcommunicate effectively. If there is a lackof collaboration and cooperation amonggroups and teams, it could (and often does)negatively impact on-time performance,

Resolving conflicts and handling day-to-day issues as they arise can help ensure that the process stays on track. Executives who empower, enable and require their leaders to focus on eliminating distractions have more time to concentrate on strategic responsibilities, which are critical to the airline’s long-term success.

One tactic is to develop and focus leaders on identifying and breaking down boundaries across business units and work teams to increase cooperation and communication throughout the organization.

Natural Tensions

schedule reliability, Crew utilization, passengersatisfaction, or, in the worst cases, passengersafety.

Mastering the overall process involvedin reducing tensions and breaking downboundaries can result in improvedorganizational performance (see figure 4).It is critical to first ensure that leaders do nothave conflicting goals, misaligned structuresor confusing processes at the top. The key isto facilitate a strategic discussion that alignsthese Executives on their own direction in

order to help them drive that direction downto the entire organization.Once leaders are clear about the strategy,structure and processes, and haveeffectively communicated it to the rest ofthe organization, employees can betterunderstand how their individual roles fit, both“in” and “across” the airline. Successfullyimplementing this process can influenceproductivity levels and lead to improvedbusiness results across the organization.

Fig 4 - All orginizational activities should fall within business strategies as support mechanisms. Effective processes shouldbe aligned with and driven by strategies - not independent of them.

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Source: Seabury OCI

ISSUE 02 – VOLUME 01

Improving cooperation and collaboration across the organization can eliminate inefficiencies, helpingto propel your airline forward by achieving key financial metrics and improving communication andcooperation. Executives who are able to apply resources to break down barriers, facilitate alignmentand eliminate inefficiencies increase their time and ability to focus on what’s most important. Whenemployees understand business goals and how their roles relate to achieving them, they feel valuedand respected and can focus on contributing more to the organization, which directly impacts yourbottom line.

Increased CollaborationThe result of effectively utilizing this processcan have significant impact. For example,Seabury worked with Crew Schedulerswho owned a process that impacted jobsatisfaction for the Crew. The problemaffected morale and crew attitudes. Welistened to the different perspectives,encouraged clarity of communication, andoutlined what specific behaviors needed tochange. In creating a consistent coachingapproach for Managers, both barriers andconflicts were addressed. The processalso helped Managers hold schedulersaccountable for specific (and now clearlyunderstood) behaviors. Schedulers hada clear perspective of their critical roles,which reduced their stress and relationshiptension. This resulted in a substantialimprovement of the Crew’s attitude towardthe airline -- and ultimately -- the passengersthey served. When employees felt morevalued, they became more productive, which

improved relations with both internal andexternal customers. Passengers recognized adifference, and Managers had more time tofocus on other initiatives.

Are there any real or perceived boundariesin your organization that are so strongand defined that they make it difficult forinformation to flow in proper channels? Arethere times when people focus too much onthe problems as they occur and notenough on proactive problem-solving andcritical decision-making? Do you want peopleto change certain behaviors, but find that youhaven’t given them an understanding of howtheir role relates to the overall strategy? Asan airline Executive, ask yourself: if I haveto get directly involved in each of thesediscussions and conflicts, how much is thiscosting my organization? And how are mycustomers affected?

Big Payoff


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Statistics - Q4 (2008)

Fig 1 - Year-on-year revenue passenger kilometer (RPK) growth versus passenger load factor (PLF). Bubble size indicates carrier size measured as available seat kilometers (ASKs)

Source: AACO

Executive Summary Includes scheduled operations for 8U, AH, EK, EY, G9, GF, KU, ME, MS, QR, RJ, SV, TU and WYStatistics cover fourth quarter 2008 operations Source: AACO

RPK Growth Q4 (% YOY)


Fig 2 - Year-on-year revenue tonne kilometer (RTK) growth versus weight load factor (WLF). Bubble size indicates carrier size measured as available tonnes kilometers (ATKs) Source: AACO

Fig 3 -Historical trend of fourth quarter passenger transit volume in most Arab airportsSource: AACO, ACI

Fig 4 - Historical trend of fourth quarter cargo transported in most Arab airportsSource: AACO, ACI

Fig 5 - Historical trend of fourth quarter aircraft traffic volume in most Arab airports Source: AACO, ACI

Fig 6 - Fourth quarter intra-regional passenger volume historical trend Source: AACO, IATA

RPK Growth Q4 (% YOY)

Departures (thousand)

Pax (million)

Tonnes (thousand)

Fig 7 - Fourth quarter inter-regional passenger volume historical trend Source: AACO, IATA

Fig 9 - Fourth quarter passenger volume in most Arab airports by portSource: AACO, ACI

PAX (thousand)

Fig 8 - Fourth quarter passenger volume in most Arab airports by port Source: AACO, ACI

Tonnes (thousand)

Tonnes (thousand)

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Fig 11 - AACO members combined fleet growth by aircraft type. Source: AACO, ASCEND

Fig 10 - Fourth Quarter domestic/regional and international passenger volume historical trend Source: : AACO Note: Includes scheduled operations for 8U, AH, EK, EY, G9, GF, KU, ME, MS, QR, RJ, SV, TU, WY

PAX(Million)

Fig 12 - Fourth quarter changes to the AACO fleet by carrier.

Source: AACO, ASCEND

www.aaco.org

16 3D Insight

www.aaco.org

Seabury Aviation & Aerospace is the largest globaladvisory firm dedicated to commercial aviation andits related businesses. The experience of our 180+professionals in strategy, operational cost reductionand restructuring is unparalleled.

Our unique team structure sets us apart from other advisors.We integrate the analytics of top-tier strategy consultants, thefunctional depth of technical experts, the financial acumen oftop bankers and the experience of former senior executives.

As a result we hit the ground running and inspire trust in ourclients by demonstrating expertise and understanding fromthe first day.

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3D Insight - AACO Insight - AACO - Seabury Quarterly... · 3D Insight A Publication by AACO and Seabury Aviation & Aerospace ISSUE 02 – VOLUME 01 May 2009. Inter-Airline Cooperation

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