Aviation Economics James House, LG, 22/24 Corsham Street London N1 6DR Tel: +44 (0) 20 7490 5215 Fax: +44 (0) 20 7490 5218 e-mail: [email protected]Issue No: 42 April 2001 Aviation Strategy Recession time? S uddenly a global recession threatens. In the US consumer con- fidence seems to have evaporated with the collapse in the price of new technology companies on the NASDAQ. Europe with less exposure to the stock markets is mostly unaffected as yet, but Asian economies, having recovered strongly from their regional crisis, are starting to look wobbly again. While the portents are ominous, it shouldn't be assumed that a recession is inevitable. The economic fundamentals remain sound - the OECD forecast produced at the end of last year predicted 2- 3% real GDP growth for most in the developed economies includ- ing the US - and the bursting of the e-commerce financial bubble should have come as no surprise. With inflation still well under con- trol, the US Fed has the opportunity of boosting the economy with another half-point cut in interest rates. The Japanese, meanwhile, are desperately trying to kickstart their economy by cutting interest rates to zero. However, assuming that some form of recession reduced global traffic growth to 2.4% this year and 4.2% next year (compared to around 6.5% in the past two years) then a serious surplus in the air- craft market emerges. This is illustrated by the graph on the next page, which is based on calculation made by ESG. As usual the traffic slowdown coincides with a period of peak deliveries (and we have excluded the 400/year RJ deliveries from the chart). The result is that the aircraft surplus (defined as the dif- ference between jet supply and the number of jets required at opti- mal utilisation) leaps from about 540 last year to 930 this year and to over 1,300 in 2002. In relative terms the surplus will peak at about 7-8% of supply compared to 10% in the early 90s. This suggests a softer airline recession compared to the col- lapse of the early 90s. There are other important differences as well. First of all, there is an obvious way to dissipate the surplus this time round - through the scrapping or sale to the Third World of the remaining non noise- compliant 727s and 737s; nearly 500 of these types are currently available for sale or lease. Generally, the major airlines have become much more adept at managing capacity over the past decade through conservative fleet addition strategies, downsizing, rightsizing and greater reliance on operating leases. The key to survival in this recession may come down to what proportion of an airline's costs are fixed and what pro- portion are variable. The leasing companies were blamed, probably justifiably, for contributing to the extent of the supply demand imbalance and arti- ficially inflating asset values. This time they are being seen in a more positive light, as providing a means of smoothing the cycle by facilitating the movement of aircraft between regions in line with demand fluctuations. Lessors have two ways of looking at the impending recession. Analysis Preparations for recession 1-2 SAir: putting together a rescue plan 3-4 Seattle’s sonic tonic 5 Has BA’s downsizing strategy worked? 6-9 Briefing Iberia: a new version of the Air France story? 11-14 US Regionals: well positioned for a downturn? 15-19 Macro-trends 20-21 Micro-trends 22-23 CONTENTS PUBLISHER www.aviationeconomics.com
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Aviation Strategy the US Fed has the opportunity of boosting the economy with another half-point cut in interest rates. The Japanese, meanwhile, are desperately trying to kickstart
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Recession time?Suddenly a global recession threatens. In the US consumer con-
fidence seems to have evaporated with the collapse in the priceof new technology companies on the NASDAQ. Europe with lessexposure to the stock markets is mostly unaffected as yet, but Asianeconomies, having recovered strongly from their regional crisis, arestarting to look wobbly again.
While the portents are ominous, it shouldn't be assumed that arecession is inevitable. The economic fundamentals remain sound- the OECD forecast produced at the end of last year predicted 2-3% real GDP growth for most in the developed economies includ-ing the US - and the bursting of the e-commerce financial bubbleshould have come as no surprise. With inflation still well under con-trol, the US Fed has the opportunity of boosting the economy withanother half-point cut in interest rates. The Japanese, meanwhile,are desperately trying to kickstart their economy by cutting interestrates to zero.
However, assuming that some form of recession reduced globaltraffic growth to 2.4% this year and 4.2% next year (compared toaround 6.5% in the past two years) then a serious surplus in the air-craft market emerges. This is illustrated by the graph on the nextpage, which is based on calculation made by ESG.
As usual the traffic slowdown coincides with a period of peakdeliveries (and we have excluded the 400/year RJ deliveries fromthe chart). The result is that the aircraft surplus (defined as the dif-ference between jet supply and the number of jets required at opti-mal utilisation) leaps from about 540 last year to 930 this year andto over 1,300 in 2002. In relative terms the surplus will peak at about7-8% of supply compared to 10% in the early 90s.
This suggests a softer airline recession compared to the col-lapse of the early 90s. There are other important differences as well.
First of all, there is an obvious way to dissipate the surplus thistime round - through the scrapping or sale to the Third World of theremaining non noise- compliant 727s and 737s; nearly 500 of thesetypes are currently available for sale or lease.
Generally, the major airlines have become much more adept atmanaging capacity over the past decade through conservative fleetaddition strategies, downsizing, rightsizing and greater reliance onoperating leases. The key to survival in this recession may comedown to what proportion of an airline's costs are fixed and what pro-portion are variable.
The leasing companies were blamed, probably justifiably, forcontributing to the extent of the supply demand imbalance and arti-ficially inflating asset values. This time they are being seen in amore positive light, as providing a means of smoothing the cycle byfacilitating the movement of aircraft between regions in line withdemand fluctuations.
Lessors have two ways of looking at the impending recession.
Analysis
Preparations for recession 1-2
SAir: putting together arescue plan 3-4
Seattle’s sonic tonic 5
Has BA’s downsizingstrategy worked? 6-9
Briefing
Iberia: a new version ofthe Air France story? 11-14
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On the one hand, in a reces-sion the credit ratings of air-lines tend to fall markedlywhile those of the leasing com-panies, backed by financialgiants like Gecas and AIG,remain solid, so improving theattractiveness of their product.On the other, they will have todeal with slumping asset val-ues and distressed clients.They may be forced into run-ning airline operations (Awas,for example, has its ownAOC).
A recession will be the acidtest for two contrasting and currently relative-ly successful strategies - rapid expansion ofcapacity and traffic around a hub system à laAir France and downsizing, total businessfocus à la BA. Early indications from the USare of a clear downturn in business travel, interms of business class seats sold and alsoin terms in business volumes as teleconfer-encing and other e-communications becomemore sophisticated.
Although e-commerce financing mayhave precipitated this recession, the fullimpact of e-distribution on the airline busi-ness has yet to be felt. Greater use of theinternet will help keep selling costs down,saving which are likely to be passed onto thepassenger via lower fares, which shouldhopefully boost traffic volumes. Orbitz nowdue for launch in June could be a majorbreak-through, representing a shift in e-distri-
bution from its DOS phase to its Windowsphase, according to its owners. (Its detrac-tors say it's nothing but a conspiracy of theUS majors.)
In Europe and the US, a recession willafford the low-cost carriers the opportunity togain market share from their full-servicerivals, both because of their cost advantageand because of the greater price-sensitivityof passengers. Unless, of course, the lowcost carrier has the wrong strategy or weakfinancing, in which case it will go bankrupt.
Bankruptcy is a real prospect for a dis-turbing number of European and Asian flag-carriers in a recession. Governments againwill face the invidious choice of bailing themout or facing the social and political conse-quences. However gruesome the prospect,the EC will have to re-open some of its stateaid files.
-4.0
-2.0
0.0
2.0
4.0
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90 91 92 93 94 95 96 97 98 99 00 01 02
TRAFFIC GROWTH MOSTLY EXCEEDEDCAPACITY GROWTH DURING THE 1990s
SAir has announced one of the mostspectacular financial results in European
aviation history - a net loss of Sfr2.9bn($1.7bn) on revenues of Sfr15bn, withSfr2.4bn of the loss related to write-offs onits airline investments.
SAir, until recently thought of as one ofEurope's financially robust airlines, is nowlooking very fragile with a debt/equity ratio of6/1 on its balance sheet. Its share priceplummeted another 30% of announcementof the results at the beginning of April, andMoody's downgraded its credit status fromA3 to Baa3, one grade above junk bonds.
SAir, under the new leadership of MarioCorti, formerly head of Nestle, is now facedwith putting together a turn-around strategyfor the whole Group. He has at least thecomfort of knowing that the Swiss govern-mental bodies, which retain a 13% stake inthe company, will probably not let the coreairline go bankrupt. State aid, in some formor another, may be necessary, which shouldbe permissible given that Switzerland is out-side the EU and the European EconomicAirspace Agreement.
Painful exitingExiting from the investee airlines looks as
if it will be very complicated, not leastbecause many of the aircraft financing dealssigned by these carriers impose seriouspenalties if the SAir link is cut.
Starting with the French situation: AOM,Air Litoral and Air Liberte are still three com-pleted uncoordinated airlines with three dif-ferent cultures producing a combined oper-ating loss of about Sfr480m in 2000. Theycontinue to suffer from union problems andface powerful competition from the TGVhigh-speed network.
One alternative is to declare bankruptcy,but such are the extent of SAir's obligationsthis would probably be the most expensiveoption, with the risk of long and tortuous
legal proceedings. The strategy could centreon selling some assets, such as the Niceoperation, where Air Littoral has a goodposition, and/or the long-haul routes to theFrench Caribbean, then restructuring thenetwork, with the aim of providing feed to analliance partner. An immediate problem isthat Air Littoral, to whom Sair has cut offfunding, would only command a distresssale price now.
Perhaps the French government willintervene - the first instance of state aid to anon flag-carrier.
Having just pumped €250m into Sabena(see Aviation Strategy, March 2001), SAirhas little choice but to stick with this airline.Here the strategy will have to be old-fash-ioned asset stripping. Cash could be raisedfrom the sale of parked A340s and otherassets. The network could be severelytrimmed as well, with transatlantic servicesbeing an obvious target, but agreementswith the unions which themselves are con-tributing to Sabena's rescue plan may limitSAir’s scope for action.
LTU has yet to see any benefits from touroperator Rewe's purchase of 40% of thischarter last year (SAir is stuck with 49.9%).The operating loss for 2000 is estimated atSfr 220m on revenues of Sfr1.6bn. An out-side possibility here would be for SAir totempt Airtours/Fti into a further expansion inthe German market by putting its share upfor sale at a distressed price.
SAir pulled out of the TAP investment(34% planned) last December and therehave been mutterings from the Portuguesegovernment about law suits. This probablywill not happen but SAir will not get awaycompletely free - it will have to provide someaircraft financing guarantees for TAP andmaybe also for Portugalia whose purchaseagreement fell through earlier in 2000.
In Italy SAir's two investee airlines,Volare and Air Europe Italy, lost overSfr100m between then at the operating level
Aviation StrategyAnalysis
April 2001
SAir - and now therescue plan
Aviation StrategyAnalysis
April 2001
last year. Problems include the expensesassociated with the introduction of new777s, low domestic load factors, competitionfrom Alitalia and, most importantly, negativesynergies from the attempted merger of thetwo airlines. The plan seems to be to contin-ue with the merger, centering operations atMilan Linate, and hope that cost savingemerge and that yield can be improved.
These two airlines could probably be soldon without too many legal complications, butthere are no obvious purchasers on the hori-zon.
LOT's operating profit in 2000 was mar-ginal - Sfr13m on Sfr1.1bn of revenues - but itwas a profit. LOT has a modern fleet, a dom-inant position at Warsaw and is by far themost successful of the former Soviet Bloc car-riers, but it does have problems winningWestern customers and is under constantthreat from Lufthansa and its Star partners.
SAir's best strategy would appear to beto keep its investment and assist in whatev-er way possible in building LOT's hub net-work. At a later date it may then be possiblefor SAir to sell its stake to BA/American aspart of the upcoming alliance re-alignmentprocess.
SAA has been the most successful ofSAir's investments, producing an estimatedoperating profit of Sfr380 in 2000 on rev-enues of Sfr2.2bn. Selling its 20% stakewould be a relatively easy way of raisingcash, though it wouldn't recover its originalexpenditure of Sfr370m. SAir's best optionhere might be to hold on to its stake until theplanned pivatisation next year which couldcoincide with SAA joining either oneworld orStar. At that point selling on the stake toLufthsansa/United or BA/American might belogical.
So from this review it becomes painfullyclear that there is no way for SAir to unloadits loss-making airline investments in thenear future. These investments were intend-ed to generate new market opportunities forSAir's successful service companies. NowSAir's service companies will have to besacrificed to cover the investment losses.
As for Swissair itself, it made a substan-tial operating loss of Sfr195m in 2000. Thecharter airline Balair lost a further Sfr25m
and even Crossair, the efficient regional sub-sidiary, went into the red for the first timewith an estimated operating loss of Sfr20m.
Swissair, if it is to survive, now at leastmust have a clear vision of the future: thisinvolves getting eventually getting rid of theSAir and Qualiflyer baggage (including thenames) and re-establishing itself as a niche,high-quality carrier linked into the oneworldalliance (becoming a BA franchisee might bea step too far).
The aim of establishing a strong positionin the EU through acquisition now seemstotally misguided. The protection gainedfrom bilateral, including its open skiesantitrust-immunised agreement with the US,is vital to its future.
Assets for saleReturning to the possible disposals - SAir
may have to sell most or all of GateGourmet, Nuance, Swissport and Flightlease. It certainly won't be able to chargepremium prices and so there could well besome bargains for the company's erstwhilecompetitors.
Gate Gourmet is the is the second largestairline catering company after Lufthansa'sLSG. LSG would certainly be interested inGateGourmet but this would raise monopo-listic concerns. It could go to one of thesmaller players like Air France's Servair,which would then have a similar global scaleto that of LSG.
Nuance is an important airport retailingand duty-free merchandiser. It could attractthe interest of similar operators like AerRianta.
Swissport is a leading supplier of third-party ground handling services. Again thebiggest competitor is a Lufthansa company,Globeground, and again a merger of the twowould attract the interest of the competitionauthorities. There might be opportunities forthe UK-based Menzies Group or the FrenchServisair.
Flightlease, the operating lease sub-sidiary, could be swallowed up by one ofseveral leasing companies or financial insti-tutions in line with the consolidation that istaking place in this sector.
There was certain panache in the mannerin which Boeing has just retreated from
the super-jumbo market. Faced with adearth of launch orders for its stretched747X, Boeing was left in the embarrassingposition of withdrawing from the market anaircraft which it had hitherto proclaimed as amuch cheaper way to achieve the same per-formance as the all-new A380. So AlanMulally, chief executive of BoeingCommercial Aircraft, decided to trumpet apaper aeroplane that has been under studyin Seattle, the Sonic Cruiser, a 180-250 -seater to fly at Mach 0.95, some 15-20%faster than conventional jets, but without thenoise problems of supersonic Concorde.
It was a public relations triumph. Seattlecitizens, rocked by Boeing's earlier decisionto move its corporate headquarters to Texasor the mid-West and to move shift somemore fuselage production to Kansas, sud-denly had a morale booster. Boeing staff arecalling the new aircraft the "Airbus-killer".
Yet there are still formidable technicalhurdles to clear if Boeing is to produce anaircraft that shaves an hour off every 3,000miles travelled without sending the fuel billthrough the roof. And the haste with whichthe proposed project was unveiled suggeststhat it is still some way off. So does the lackof specific information on its performance.
Whatever the underlying status of theSonic Cruiser, it is still a remarkable turn-round for Boeing. As late as last OctoberAlan Mulally was confident he was about tosign up his first launch customer for the 747X.He had set his sights on Fedex, becausecargo carriers had been showing interest inever-larger aircraft. In the event, the Fedexorder went to Airbus helping it reach the totalit needed to formally launch the A380 inJanuary; it now has 66 orders and 50 options.
Although it seems inconceivable thatBoeing can walk away from the market forsuper-jumbos, it has for years been talkingup the idea that international aviation is frag-menting and that travellers increasingly wantto fly point-to-point rather than go throughbig hubs. It claims that the fragmentation it
detects across the Atlantic is about to berepeated over the Pacific.
Based on this analysis Boeing has fore-cast only a small market for around 350super-jumbos, compared with 1,550 in theview of Airbus. One reason for the huge dif-ference is that Airbus claims that the A380 isa contender to replace the existing 747 so itcounts the market for everything over 400seats, while Boeing still sees that as a sepa-rate market, about the same size as that forthe super-jumbo. But the essential differ-ence between the two manufacturers is thatAirbus believes the sheer volume of trafficflying between slot-constrained airports cre-ates a market for the A380.
Airbus disconcertedPrivately Airbus executives cannot really
believe that Boeing is walking away from whatthey see as a large and lucrative market,where they saw profits from the A380, even ifit shared it equally with a Boeing product.
The nightmare that Airbus faces is thatA380 orders, now that launch discounts willno longer be offered, slow to a trickle. BA con-tinues to spurn the A380 and rely instead on777s, despite facing continuing congestion atHeathrow, which the A380 is supposed toresolve. Another worry for Airbus is that whenthe sonic cruiser is finally launched, airlineslike BA will use it to cream off business trav-ellers on key routes, leaving the mass marketfor A380s and in the process undermining theaircraft's economics (certainly no moreonboard jacuzzis or casinos).
Perhaps the most interesting facet ofBoeing's behaviour is how different it is fromthe past. When the original Airbus twin-engined widebodies were unveiled, Boeingdismissed them as ill-conceived and notwhat the market wanted, before going on tolaunch its own first twin-widebody, the 767. Asimilar thing happened when the A320 waslaunched, precipitating the 737NG project.This time Boeing has finally decided to go itsown way and refuse to follow an Airbus ini-tiative.
Aviation StrategyAnalysis
April 2001
Seattle's sonic tonic
In the mid-1990s, British Airways started tosee that it was going to encounter some
serious profitability problems. It had beencoasting for many years in the knowledgethat it was the best of the European bunch,that it had a very strong natural demand ofpoint to point passengers to and from itsfortress at Heathrow, and that because itwas operating under a relatively weak cur-rency it had the opportunity to use its supe-rior route network to attack the lower valuebut incremental transfer traffic through itstwo "hubs" of Heathrow and Gatwick - andthis it accelerated following the fall ofSterling in the ERM crisis in 1995.
It had been growing capacity stronglybased partly on the assumption that itsalliance partnership with American would beconsummated, that as a result it would haveto accept open-skies, and that the restric-tions at Heathrow and Gatwick would requireit to have larger aircraft in order to maximisethe use of its limited number of slots.
Neither of its main airports can be truehubs: they are both slot constrained, LHRwith only two runways and LGW with one,neither has thepossibility for newrunways: it wouldbe impossible forBA to try to estab-lish a wave systemto maximise inter-connection poten-tials.
However, theeconomics of itsoperations wereweakening. It hadseen its Europeanoperations resultsdecline into loss-es. It had alreadycut much of itsn o n - e s s e n t i a le x p e n d i t u r e
through disposals and outsourcing and hadlittle further cost-saving to find. Since privati-sation it has always been highly profitableand shareholder-orientated and the man-agement could see that it would be increas-ingly difficult to maintain improvements inreturns to shareholders while unit costs grewfaster than unit revenues.
In addition, the competition was becom-ing serious. Many were seen to havematched BA's product quality, while its ownquality standards had slipped. It was "goingthrough a bad patch". Lufthansa was achiev-ing the success in generating a globalalliance that BA lacked, had seriouslyimproved its market offering and had startedto make Frankfurt and Munich into reallycompetitive hubs (although it did not havethe point to point market of which BA canboast).
Whereas ten years before, BA had thelargest number of gateways available in theUS of any European carrier, and could boastthe largest international number of destina-tions, with London being the first landfall citydestination for many long haul flights, the
Aviation StrategyAnalysis
April 2001
Has downsizingworked?
CALCULATION OF CVA
Yields, volumes
Working capitalmanagement
Unit costs
Investment strategy
Financing strategy
REVENUE
OP. COSTSTAX
ASSETREPLACEMENT
ASSET BASE
EQUITY
DEBT COST OFCAPITAL
SUSTAINABLECASH PROFIT
CAPITALCHARGE
CVA
minus
x
minus =
=
competitors were increasingly developingroutes that bypassed Heathrow and thecode shares available to its European com-petitors from their anti-trust immunity statusremoved the gateway superiority that thecompany previously could boast.
In addition, Air France was finally startingto get its act together in its target towardsprofitability and privatisation. It uniquely hadthe potential to offer a really competitive hubin that it had a good level of point-to-pointdemand at its base in Paris as well as thespace and the political will to develop CDGinto a strong wave-based hub of operations(the fourth runway comes on stream thisyear).
Furthermore, the terminal capacity thatwould be provided by the fifth terminal atHeathrow will not now be available beforethe end of the current decade - andHeathrow needs the capacity for handlingpassengers now.
BA started a major review of strategy.The main plank of this review was a corpo-rate financial target of Cash Value Addedreturns - to enable the proof that the compa-ny was not destroying capital in any elementof its business. Simply speaking it needs toachieve a real CVA return in excess of itsweighted average costs of capital (WACC)of 7% post tax. On top of this the companyuses this financial tool to put their ownresults into context, to provide the basis fordecision making particularly in capitalexpenditure, acquisitions and disposals, andin analysing their own business. The compa-ny's results were falling far short of the tar-get: there were three ways to improve thereturns: raise revenues, cut costs, cut capitalemployed in the business.
This financial strategy was applied to allsegments of the business. For the passen-ger business is emphasising the improve-ment in revenues and the reduction in capi-tal. The company tried to identify each of themajor demand segments, the assets andasset value applied, and the returnsachieved. This has always been difficulteven in an industry with such a plethora ofdata. The prime difficulty is in applying thecorrect algorithm for the allocation of costsand revenues accurately over multi-segment
flights. The simple form of the analysis split the
demand segments into a three dimensionalmatrix of Long Haul and short haul, point topoint and transfer, premium traffic and econ-omy. The revenue and profitability were thencompared to the estimated asset valueemployed in the acquisition of each demandsegment. The chart of this analysis, original-ly reproduced in the March 2000 issue ofAviation Strategy, has become known asSpurlock's Balloons after the company'sstrategist.
From this BA could prove to itself that itcould not afford to concentrate on acquiringshort haul to short haul, or long haul to shorthaul economy transfer traffic - and evenshort haul to short haul point to point econo-my traffic was destroying value.
The brave element of this analysis wasthe attempt to turn the traditional view of air-line operations on its head: that the acquisi-tion of marginal traffic was important as longas the marginal cost of acquisition did notexceed the marginal revenue acquired. Indoing so it showed the promise of applying amodified form of enterprise value addedanalysis to the airline business.
Aviation StrategyAnalysis
April 2001
PROFITABILITY OF BA’S BUSINESS SEGMENTS
+ve
-ve
0
Grow &Defend
ImprovePosition
& Mix
ReduceExposure
Prof
itabi
lity
Asset Value £
Size of bubble = Revenue
SH P2PPremium
LH P2PPremium
LH P2PEconomy
SH P2PEconomy
LH:SH Economy
LH:LHPremium
LH:LHEconomy
LH:SHPremium
SH:SH Economy
SH:SH Premium
SH = Short haul; LH = Long haul; P2P = Point to Point
The conclusions available from thisanalysis were aided substantially byBoeing's introduction into service of the 777(and for that matter Airbus' introduction ofthe A-330). For the first time in the Jet era,there was a new aircraft that offered a lowerseat unit cost without having more seats.BA's previous long haul strategy had reliedon the 747. To feed the transfer traffic fromshort haul onto long haul it needed relativelylarge short haul aircraft. To acquire the traf-fic to fill the seats on the large long haul air-craft it needed to discount.
In the words of the company strategist,"bulk seats do not make returns to share-holders, frequencies, destinations and a pre-mium product do".
The conclusion was simple: downsizeand concentrate on premium traffic. Thecompany switched existing 747 orders toslots for 777s. It decided to accelerate itscapital expenditure programme substantiallyto replace the older 747s with 777s. It intro-duced a new subfleet with the decision toacquire aircraft from the A320 family toreplace the older 737s and 757s.
It developed a route strategy to removeexposure to non-performing destinations,cut individual flight capacity and increase
frequencies. When the strategy was promul-gated, the company was unfairly criticisedfor turning its back on the economy leisurepassenger. It is not. It is accepting that itsshareholders cannot allow it to afford to flypassengers at a loss.
The conclusion was simple; but turning aship around as big as an oil tanker going atfull speed is not, and the implementationtook time. The board took the decision onthe new strategy towards the end of the1998 financial year. The fruits are just start-ing to show.
ProductOnce the analysis was there, and the
conclusion to emphasise the acquisition ofpremium traffic, the company had to consid-er raising the level of its premium class offer-ing well above the competition. Since privati-sation BA has been strongly brand marketoriented, maintaining a portfolio of brandsspecifically targetted to its demand seg-ments - and as such is one of the few carri-ers world-wide that has successfully seg-mented its brands.
One of the main trends in consumer mar-keting is that product life cycles are shorten-ing and that brands need to be relaunchedincreasingly frequently. Since the last intro-duction of its business brand "Club World",the competition had caught up. Many haddispensed with a first class offering and nowprovided a business class space and com-fort level substantially higher than BA's -effectively equivalent to the first class offer-ing of 25 years ago.
BA needed to revamp a tired brand. Itstood the equation on its head and designeda business class product nearly equivalentto a first class product on any other carrier. Ittook a close look at what its business pas-sengers wanted on long haul: the ability tosleep, to work and relax. As a result itpatented a seat that like its first class prod-uct reclines to a flat bed; it introduced priva-cy screens; it provided laptop power points.
The roll-out of the brand has been slowand connected with the timing of the deliveryof the 777s and major checks on the newer747s. The first aircraft embodied with the
Price per pax +4%Load factor +6 pointsRev per seat +13%
THEORETICAL REVENUE IMPACTOF DOWNSIZING
Source:BA, March 2000
new configuration took off in March 2000 -and initially flew on the company's busiestNorth Atlantic routes. BA has now fitted out35 of its long haul aircraft with the new clubbeds including the first nine 777s. All aircrafton flights to HKG, SFO, MNL, TPE, ORD,JFK, EWR, NRT are fully embodied. Thoseon routes to IAD, LAX and JNB are in theprocess of embodiment.
The new Club brand offering then pro-duced an additional problem - one thatperennially appears in upgrading a subbrand. The new club class could be seen todetract from the first class product. As aresult it was necessary to relaunch the firstclass product to maintain the apparent dif-ferential in pricing from the business classoffering. The improvements include in seatpower, better lumbar support, in-seat tele-phony and a redesigned cabin interior.
At the same time the company intro-duced a fourth class. This is in recognition ofthe number of passengers who travelling onbusiness fly in the back of the bus but effec-tively pay the full economy fare. (It is neverreally nice as a traveller to find that whereasyou paid $1,500 for a flight the guy next toyou paid $300). The new World TravellerPlus cabin offers more leg room and theequivalent almost of the early business classproducts.
With the new route strategy, the compa-ny also refurbished the short haul businessbrand: Club Europe gained new leather
seats, new interiors and a new cateringproduct. The new aircraft fittings includemuch larger overhead bins and the companyallows a friendlier hand baggage policy. Theroll out started in the summer of 1999 andcompleted in autumn 2000. The result hasagain been a jump in customer satisfactionmarket share and revenue.
ScorecardThe conclusion must be that the strategy
has started to work - and that this is startingto be felt in the results. The airline's capaci-ty has now peaked and is set to fall over thenext two years. Unit revenues have startedto rise strongly. Although - as is usual whenan airline shrinks - unit costs will rise, it
appears that on balance unitrevenues should rise faster andthat BA should finally be able toachieve a positive gap betweenits WACC and CVA return. Oneconsequence of a reducedexposure to back-of-the-bustraffic may well be a lower cycli-cality in its returns and may pro-vide some defence againstshort term fluctuations in leisuredemand. Downsizing inadvance of a recession nowappears to be a sound strategy,but the big unknown is the effectof intensified competition forbusiness travellers.
Aviation StrategyAnalysis
April 2001
IMPACT ON LONG HAUL ROUTES (Oct-Nov 2000)ASKs Unit Rev. Profit Fleet change
LGW-US -14% +48% +£2.5m 747-200 to 777LHR-US -8% +24% +£1.8m 747-400 to 747-200LHR-Asia -37% +53% +£1.7m 747-400 to 777
IMPACT ON SHORT HAUL ROUTES (Oct-Nov 2000)ASKs Unit Rev. Profit Fleet change
LHR-Scandinavia -21% +35% +£2.1m 767 & 757 to 757 and A319LHR-Mediterranean -15% +31% +£1.9m 767 to 767 & 757LHR-Benelux -13% +42% +£1.7m 757 to A319 & 737-400
ACTUAL EFFECT OF FLEET CHANGES
Note: Change against same period of 1999
By JamesHalstead
0%10%20%30%40%50%60%70%80%90%
100%
1999 2003 1999 2003
IMPACT ON PASSENGER MIXPax nos. Pax rev..
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Aviation StrategyOnline
April 2001
THE INTERNET VERSION OFAVIATION STRATEGY
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CUSTOMISED COMPANY AND MARKET BRIEFINGS
If you are interested in a briefing on a particular airline, manufacturer,lessor or industry sector/market, Aviation Economics is able to produce
Iberia is the latest European carrier to befully privatised. It hopes to emulate the per-
formance of Air France by transforming itselffrom an inefficient, state-supported flag-car-rier to a commercially successful airline withan important role in a global alliance.
The Spanish state holding company,SEPI, is selling its 53.9% stake in the airlineto both institutional and private investors.The remaining 46.1% of the airline was soldin March 2000 to a group of core sharehold-ers - British Airways (9%), American Airlines(1%), the employees (6%) with the remain-ing 30.1% being held by a number of largeSpanish companies.
The pricing of the issue was subject tomuch press, commercial and politicaldebate. The initial price range of between€1.71 to € 2.14 per share would have val-ued Iberia at between € 1.56bn and € 1.95bn ($1.39bn to $1.74bn). Although the localretail demand (private investors) appearedadequate, with indications of a 1.5 timesover-subscription, institutions were highlycritical of what they perceived to be over-pricing of the issue. So at the beginning ofApril the price was lowered to € 1.19, capi-talising the airline at € 1.1bn, at which pricethe issue was three times over-subscribedby the institutions.
For potential investors, the main salesmessage was Iberia’s potential for aboveaverage growth and the management's abil-ity to continue to deliver profits post the air-lines' dramatic financial turnaround. At aMerrill Lynch conference in March, EnriqueDupuy de Lome Chavarri, Iberia's FinanceDirector, held out the potential for doubledigit EBITDA growth in the next two years.
Although Iberia is the sixth largestEuropean carrier, it is firmly in the secondrank of European airlines behind the bigthree - British Airways, Lufthansa and AirFrance. It is smaller than KLM and Alitalia inRPK terms, but ahead of Swissair, VirginAtlantic and SAS.
Iberia's specialist role has always beenas being the main carrier from Europe to theSouth American market. Unfortunately, thepace of economic development of SouthAmerica has been disappointing, as themajor countries, Brazil and Argentina, con-tinue fail to fulfil their immense potential.However, Iberia has been increasing itsshare of the Europe-South America marketand now holds a top-ranked 15% marketshare, some five points ahead of Air Franceand British Airways.
IATA predicts that the Spanish scheduledmarket will be the fastest growing of themajor global air travel markets between2000 and 2004. Its forecasts show theSpanish international scheduled passengermarket growing at 6.5% p.a. for the period2000-2004 and the Spanish domestic mar-ket by 10.2% p.a. over the same period. Onereason is that Spain remains well below theEuropean average in terms of airline pas-senger journeys per head of population atjust over one journey versus an European
Aviation StrategyBriefing
April 2001
3,000
4,000
5,000
6,000
95 96 97 98 99 00 01* 02*
IBERIA GROUP’S OPERATING REVENUES
Note: *Merrill Lynch forecast.
Euros m
-500-400-300-200-100
0100200300400500
95 96 97 98 99 00 01* 02*
Operating result
Pre-tax result
Note: *Merrill Lynch forecast.
IBERIA GROUP’S FINANCIAL RESULTS Euros m
average of over 1.5 journeys per head.Like Air France, Iberia growth in the
1990's was stifled by poor financial healthand by restraints placed upon the carrier bythe European Commission. Again like AirFrance, this holds out the prospect of Iberiaachieving above average traffic growth ratesthrough re-gaining "natural" market share.Also, just as Air France has benefited huge-ly from its uncongested hub at CDG, Iberiaenjoys has more or less unfettered growthpotential at its Madrid and Barcelona hubs.
Madrid-Barajas has permission to doubleits existing two runways to four by 2004, andairbridges are set to increase from 40 todayto 97. Iberia operates a five-wave system atMadrid but connecting traffic is hampered bythe fact the airline operates from three sepa-rate terminals. By 2004 Iberia and itsoneworld partners will be housed in a singlenew terminal.
At Barcelona Iberia operates a three-wave system. By 2004, Barcelona will haveadded a third runway and double the num-ber of available airbridges to 48. A new ter-minal is scheduled to open in 2005.
Like Air France, Iberia proved slow toadapt to the liberalised regulatory environ-ment and needed to be rescued throughgovernment state aid injections whichtotalled € 1.4bn since 1992. The EC took aclose interest in the affairs of Iberia when theairline returned for a second round of state
aid in 1994, with some lame excuses about"exceptional circumstances". The conditionsimposed by the EC forced Iberia to tacklefundamental problems. Under new manage-ment headed by ex-General Electric execu-tive Xabier de Irala, excessive costs wereattacked; during the period 1994 to 1996Iberia shed 15% of its staff, and salarieswere frozen.
The EC also required Iberia to sell itsLatin America investments, which hadproved to be a disastrous cash drain on thecarrier without providing any significant mar-ket benefits. Its stake in AerolineasArgentinas has been reduced from 83% to0.35% and has been fully provisioned; the38% stake in Ladeco was sold in 1998; andViasa, in which Iberia held a 45% stake,went bankrupt in 1997.
Iberia enjoys a 70% share of the Spanishdomestic market, the second largest domes-tic market in Europe (behind France). With arecorded growth rate of 13% in the year2000, the Iberia management expects thatfuture domestic growth rates could continueto be double digit, and that the Spanish mar-ket will in turn overtake the French market.
The former domestic carrier,Aviaco, wasconsolidated into the Iberia Group someyears ago (Iberia bought the 67% of Aviacoit did not already own from SEPI in 1998 for€234m), and Iberia also owns two regionalcarriers, Binter Canarias and BinterMediterraneo. Its franchise agreement withAir Nostrum extends Iberia's control over thedomestic market, but its recent attempt tobuy the second largest carrier, Air Europa,has failed.
The Air Europa/Iberia negotiations appar-ently foundered for two reasons. First, aspart of the deal Air Europa chairman JuanHidalgo would have received 10% of Iberiawhich other shareholders objected to.Second, Iberia's pilots were concernedabout the impact of incorporating Air Europapersonnel.
Iberia presently enjoys a lower cost basethan its scheduled northern European rivalsrivals thanks largely to its lower labour costs.Iberia's financial traumas in the first half ofthe 1990s ensured that employees wereforced to accept almost draconian terms to
Aviation StrategyBriefing
April 2001
IBERIA’S FINANCIAL OUTLOOKEuros m 2000 2001* 2002* 2003*Group revenues 4,489 5,010 5,344 5,652Group op. profit 66 103 137 165Operating margin 1.5% 2.1% 2.6% 2.9%Pre-tax profit 221 155 162 190Pre-tax profit margin 4.9% 3.1% 3.0% 3.4%Source: *Merrill Lynch estimates. Note: Exceptional items amounted to Euro49m in 1999, Euro153m in 2000 and an expected Euro 36m in 2001, Euro 9m inboth 2002 and 2003 as a result of the sale of aircraft, property and other assets.
IBERIA’S SEGMENTAL GROWTH PLANS 2000-03Domestic European Long- Network
haul totalDestinations 34 41 26 101Average daily frequency 296 144 24 464Daily frequency increase 20 42 4 66% increase in frequency 6.8% 29.2% 16.7% 14.2%Forecast revenue mix 2003 34.5% 32.2% 33.3% 100.0%Source: Iberia and Merrill Lynch estimates.
keep the company afloat. Perhaps the great-est challenge facing management is toensure that future wage agreements do notundermine the progress made. It should alsobe remembered that international trafficflows to Spain are dominated by UK andGerman charters (about 80% of the total)whose unit costs Iberia cannot hope tomatch.
There is potential for the airline toimprove productivity. Average aircraft utilisa-tion is presently a somewhat pedestrian 7.6block hours per day, and the managementhave targeted an 18% increase to 9 blockhours per day. Pilots have also undertakento fly 20% more block hours per month.
Iberia is also looking to the Internet toreduce distribution costs. Currently 1.5% ofpassenger revenues are derived from theInternet. The target set by management is toachieve direct ticket sales of between 28%by 2003, 7% through Iberia.com and21%through virtual travel agencies.
Competitive threats
The Spanish market is being targeted bythe fast growing low cost airline sector. BothGo and easyJet serve Spanish destinationsfrom the UK and Switzerland. So far perhapsEurope's most aggressive low cost competi-tor, Ryanair, has avoided the Spanish mar-ket probably because it has been unable tocomplete any airport deals in the country.Spain's airports are almost exclusively con-trolled by publicly owned AENA, and so far itis not willing to break its strict pricing policy.
A high-speed rail link is set to openbetween Madrid and Barcelona in 2004. Thisroute today accounts for 25% of totaldomestic passengers in Spain (5m passen-gers in 1999) and has strong business ele-ment (42% of the total), which accounts foryields on the route being 28% ahead of thedomestic average. Iberia operates a shuttleservice on the route and enjoys a 78% mar-ket share. It is Iberia's belief that when therail service opens it may lose 20% of its mar-ket share on the route.
Iberia is the only carrier with a conces-sion to operate handling services at all 37 of
Spain's major commercial airports. Theintroduction of competition in the market, fol-lowing EC directives, has reduced Iberia'sshare of third party ground handling to 65%.In March 2000, 15 of Iberia's sole handlingconcessions were opened up to competitivetender, with Ineuropa and Eurohandling pro-viding the prime competition.
Alliance silenceIt is interesting that the sales message
being pushed the airline's management andby the investment bankers which are incharge of the privatisation process places lit-tle emphasis on the alliance front. In March2000, British Airways acquired a 9% stake inIberia and American Airlines a 1% stakewhich secured Iberia's position in theoneworld alliance, which it joined inSeptember 1999.
Iberia estimates that the incremental feedgenerated from its oneworld alliance part-ners (it is assumed mostly BA andAmerican) is some Euro € 120m in annu-alised revenue benefits, which amounts to3.3% of total passenger revenues in 2000. Apotential re-launch of oneworld this year,with closer co-operation between BA andAmerican, should generate more revenue inthe future for Iberia.
BA and American were able to negotiatea very prudent deal with Sepi when theyacquired their respective stakes in Iberia.Although they bought into Iberia at Euro 3.50per share it was agreed that this price wouldbe reduced to match the price upon flotation.Both carriers therefore look set to receive asubstantial rebate on the consideration theypaid to Sepi in March and December 2000.BA’s rebate is estimated to be in the order of€100m.
Future strategy
Management is focussed on trying toincrease average yield through network andproduct developments. Passenger yields atIberia are perceived to be below Europeanaverages (adjusted for stage length). Forexample, Alitalia, which has a similar aver-
Aviation StrategyBriefing
April 2001
age stage length to Iberia, enjoys averagepassenger yields that are 6.3% aboveIberia's.
At present only 14% of Iberia's intra-European traffic is premium, a proportionwhich Iberia hopes to improve through theintroduction of "variable geometry" seatingin new aircraft which will permits a 25%increase in business capacity. On Iberia'slong-haul routes, only 9.3% of its passen-gers fly in business class cabin versus anestimated European carrier average of 13%.A target of a 3.6% improvement in nominalunit revenues has been set for 2003 versusthe year 2000.
Future capacity growth will be aimed atre-capturing and improving market share inthe Spain-Europe markets, and consolidat-
ing its number oneposition in theE u r o p e - L a t i nAmerica marketsand the Spanishdomestic market.Merrill Lynch esti-mates show Iberiaincreasing capacity(ASKs) by 10.2% in2001, 7% in 2002and a further 7% in2003. The plan is toincrease frequencyrather than estab-lishing new routes,again with the aim ofimproving the attrac-
tiveness of the network to the business trav-eller.
The impact of the fleet renewal pro-gramme will see the average age of the fleetfall from the current 9.1 years to 7 years by2003. In addition significant cost savings areexpected from a reduction in the number oftypes from nine to six.
The fleet plan has some in-built flexibility,which will be a source of comfort forinvestors given the uncertainty of the eco-nomic and traffic outlook. A combination ofthe non-exercise of options, the non-renew-al of operating leases and the termination ofcontracts of aircraft which are expected tobe wet leased during the period would see a2003 year end fleet of 152 aircraft, 16% lessthan the current plan.
As the earnings outlook for the US majorairlines has deteriorated, there has
again been a surge of interest from investorsin regional airline stocks, which have provedrecession-resistant in the past. Carriers likeAtlantic Coast (ACA), SkyWest and Mesahave recently placed substantial new region-al jet orders, and their shares look underval-ued in light of the strong capacity and profitgrowth potential. Will the regional airline sec-tor live up to the expectations?
In many ways, US regional airlines seembetter positioned for an economic downturnthan ever before. First, the earlier fears thatscope clause restrictions in major carriers'pilot contracts might hinder RJ expansionhave proved unfounded. Many of the region-als now look set to continue to growextremely rapidly for the foreseeable future.
Second, the increasingly prevalent fixed-fee type financial arrangements between themajor carriers and their regional partnerseffectively protect the smaller airlines fromthe effects of a softening economy.
Also, as Embraer's CEO MauricioBotelho argued in a recent conference call,regional airlines may even benefit from aneconomic downturn now that their RJ fleetshave expanded. Because of their comfortand good passenger perception, regionaljets have changed the way markets aredeveloped. The major carriers will havemore incentive to transfer recession-impact-ed, lower-density short haul routes to theirfeeder partners, because there is little risk oflosing traffic and valuable market sharewhen downsizing from large jets to RJs(rather than turboprops).
Rapid capacity growth
The regional sector has grown extremelyrapidly since the mid-1990s as the processof utilising regional jets has gathered pace.The US RJ fleet expanded from just 35 air-
craft five years ago to 569 in 2000, which ledto annual capacity growth as high as 20-30% for some operators. However, untilrecently carriers like ACA and SkyWest werein limbo in respect of longer-term plans,unable to get authorisation from their part-ners to firm up conditional RJ orders. Thenagging concern was whether the major car-riers' pilot unions would permit continuationof rapid RJ deployment.
A major breakthrough came in October2000, when United's pilots ratified a newlabour contract that gave them the wageincreases they wanted. They agreed to relaxsubstantially the RJ scope clause provisionsin their contract. The number of RJs allowedin United Express service went up from 65 to102 immediately, and the total is expected toreach 390 by the end of 2002.
As a result, ACA, United's partner atChicago and Dulles, secured an expanded10-year United Express agreement. It wasable to firm up a long-delayed conditionalorder for 30 Bombardier CRJs and place anew order for 32 Fairchild Dornier 328JETs.SkyWest, in turn, placed a $1.4bn CRJ orderin January for United Express operation inDenver and West Coast markets. Further RJorders from those carriers are clearly on thehorizon, just waiting for United to sort out itshub priorities after its possible acquisition ofUS Airways.
ly to benefit from the United pilot deal,because other major carriers will eventuallyhave to match United's pilots' wages and/oraccelerate RJ expansion for competitive rea-sons. In that respect, the United pilot dealwas really a watershed development.
Delta, which currently has no RJ limitsbut is under pressure from its pilots to intro-duce such limits, is now likely to end up witha relatively liberal scope clause or none atall. Of course, both ACA and SkyWestalready have firm arrangements in place togrow their Delta Connection RJ fleets to 50and 46 aircraft respectively in three or fouryears' time.
In March America West, which has no RJscope clause limits, announced that itsregional jet operations would expand fromthe current 22 to 77 aircraft by 2005, withoptions for further growth to 129 aircraft. Theadditional RJs will help defend the Phoenixhub against Southwest and strengthen theLas Vegas and Columbus hubs.
Consequently, Mesa secured a tentativenew long-term contract to operate up to 83additional RJs for America West Express atPhoenix and Las Vegas, while Chautauqua(already a US Airways Express and TWAExpress RJ operator) was signed up as anew regional partner at Columbus. Mesaimmediately signed an LoI to buy up to$1.2bn worth of Bombardier's new 70-90seat jets, becoming the launch customer forthe CRJ-900.
All of this has ensured continuation (or insome cases resumption) of extremely strongcapacity growth for the independent region-
als until the middle of the decade - andlonger if the options are exercised. ACA nowexpects its RJ fleet to triple to 158 by the endof 2003, which will mean 35% averageannual ASM growth. After last year's pause,SkyWest's ASM growth will return to double-digits this year and will average around 37%in 2002-2004, as it increases its RJ fleetfrom the current 16 to 130 by the end of2004. The expanded America West contractwill enable Mesa to grow its capacity by atleast 20% annually over the next few years.
In its latest annual forecast, the FAA pre-dicts that the aggregate US regional jet fleetwill surge from last year's 569 to 2,190 air-craft in 2012, when it would represent morethan one third of the size of the large pas-senger jet aircraft fleet. However, longer-term expansion of that magnitude may notbe possible because of ATC and airportcapacity constraints.
Stable earnings growth,but new risks
Just about all the new or expanded con-tracts signed between the majors and theirfeeders in recent years have been on afixed-fee or fee-per-departure (rather thanpro-rate or revenue sharing) basis. This hashad a major impact on the economics of theregional airlines' operations.
Under the new arrangements, the majorspay a flat fee per flight (in other words, buythe capacity from the regional), plus typical-ly an incentive payment per passenger ifspecific operational performance and ser-vice standards are exceeded. The basic feecovers all costs and allows for an operatingmargin. This means that the regional makesthe same amount of money regardless ofwhat the fares are and how many passen-gers are on board - obviously useful in aneconomic downturn or a weak fare environ-ment.
Also, fixed-fee contracts eliminate riskfrom fuel price fluctuations or operationalproblems experienced by the major carriers.When fuel prices surged last year andUnited was plagued by operational prob-lems, ACA and SkyWest were unaffected.
Aviation StrategyBriefing
April 2001
$m
Net result
Note: FY = to March 31st. *First Call consensus estimates.
Operatingrevenue
SKYWEST FINANCIAL RESULTS
The new contracts make extremely high(20%-plus) profit margins a thing of the past,but they remove risk and ensure a stableand predictable earnings stream, both on aseasonal and year-over-year basis. Analystssay that operating margins of up to 15%, oreven 18% in some cases, are still possibleunder fixed-fee flying.
However, earnings stability is not guaran-teed as fixed-fee remuneration poses itsown risks and challenges. The key require-ment is that the planned flying must takeplace, because earnings growth will be high-ly dependent on capacity growth. Also, thenew contracts make it imperative to maintaingood operational performance and servicestandards.
The three most obvious things that canreduce ASM production are weather disrup-tions, labour actions (at the regional airline)and poor execution of ambitious growthplans. By far the biggest challenge is tomake sure that the infrastructure andemployees will be in place to support rapidexpansion.
In recent months several carriers havedemonstrated some of the downside offixed-fee flying - and also that regional air-lines can still be adversely affected by aweakening economy. As a result, SkyWest's,Mesa's and Mesaba's earnings this year willnot be quite as strong as expected earlier.
All of those carriers have suffered froman unusually high number of weather-relatedcancellations. SkyWest and Mesaba havealso seen their flight crew and trainingexpenses soar, as they have obviously hadto continue to prepare for growth despite asoftening economy. At least in SkyWest'scase, pilot costs have exceeded the annualmaximum reimbursed through its fixed-feecontracts. However, such issues are onlytemporary under fixed-fee flying - highercrew costs will be allowed for in the subse-quent fiscal year's reimbursement plan.
But SkyWest has also felt the effects of asoftening economy in its pro-rate DeltaConnection markets, which account for 30%of its revenues. And, according to UBSWarburg analyst Jamie Baker, Mesa hasreported deteriorating fundamentals in itspro-rate US Airways Express turboprop mar-
kets, which still generate a substantial 40%of its total revenue.
While airlines like Mesa and SkyWest willcontinue to be affected by the economybecause they still have pro-rate flying, theirearnings growth will still be much higherthan that of the major carriers. SkyWest iscurrently expected to return to strong earn-ings growth when its growth accelerates inthe latter part of this year.
Structural stability at last?
1999 was a turbulent (albeit still prof-itable) year for the US regional sector asDelta swallowed Comair and AtlanticSoutheast (the two most profitable region-als), AMR purchased Business Express andintegrated it with American Eagle, andContinental acquired a stake in GulfstreamInternational. There was much speculationthat the major-regional consolidation trendwould continue.
However, except for Northwest's proba-ble acquisition of Mesaba, that seems tohave been the extent of it. ACA, SkyWestand Mesa were able to retain their indepen-dence because they had already forgedstrong feeder relationships with multiplepartners, because they embraced the fixed-fee contract concept and because theymaintained or improved operational and ser-vice standards.
The proposed UAL/US Airways mergernow presents an opportunity to reversesome of the earlier process, because Uniteddoes not want US Airways' three wholly-owned regional subsidiaries. United believes
Aviation StrategyBriefing
April 2001
-200-100
0100200300400500600
93 94 95 96 97 98 99 00 01*
Note: FY = to September 30th. *First Call consensus estimates.
Operatingrevenue
Net result
$m MESA AIR GROUP FINANCIAL RESULTS
that it could not operate the carriers prof-itably under its much higher wage levels (asrequired by its flight attendants' contract),and owning feeder partners is not consistentwith its strategy.
The main beneficiary is likely to be ACA,which recently signed a conditional agree-ment with United that gives it the right of firstrefusal for any two of the three carriers -Allegheny, Piedmont and PSA Airlines. It isalso possible that airlines like Mesa will geta piece of that pie.
At this point there are no commitments. Ifthe UAL/US Airways merger closes, ACAand United will negotiate the purchase priceand other details over an 18-month period,during which ACA can pull out without penal-ties. All of its costs would be reimbursed,and the carriers would be operated as sepa-rate subsidiaries during the transition period.
James Parker, analyst with RaymondJames & Associates, believes that since theairlines would sign fixed-fee type UnitedExpress agreements, the acquisition wouldenhance ACA's already very favourableearnings outlook. However, this view is notshared by everyone on Wall Street as thereare the usual concerns about a potentiallyincreased debt burden and the disruptiveeffects of mergers. Some analysts have low-ered ACA's stock recommendations, and its
credit ratings look likely to be downgraded ifthe acquisitions take place.
Late last year Northwest offered to buythe remaining 72% of Mesaba that it doesnot already own for $13 per share - a movethat had been expected for years as all ofthe small carrier's operation is under a code-share agreement with Northwest. The talkshave been plagued by disputes about con-tract payments and appear to be at a stand-still, but the outcome seems inevitable.
Atlantic CoastAtlantic Coast is probably the best-posi-
tioned of the publicly traded regionals forseveral reasons. First, it has highly success-ful feeder relationships with both United andDelta (about a 78%/22% revenue split).Second, 100% of its operations are now ona fixed-fee basis. Third, it has the largest RJfleet and the largest RJ orderbook. Fourth, itis strong on the East Coast and present atthe key hubs (Chicago and WashingtonDulles), making it ideally positioned to bene-fit from the planned UAL/US Airways merger.
The company is realigning the fleets of itstwo units, ACA and ACJet (the new DeltaConnection operation at LaGuardia) andblending their managements to enhance effi-ciency. ACJet's operation, which will grow to
30 aircraft by year-end, willfocus exclusively on the328JET. The United Expressoperation will utilize bothCRJs and, from early nextyear, 328JETs, which thecompany suggests would beideal for many US AirwaysExpress routes. The aim is tobecome an all-jet operator bythe end of 2004.
There appear to be nolabour issues. ACA andACJet pilots recently ratifieda new 4.5-year contract thatoffers industry-leading payrates.
Earnings outlook isextremely favourable, giventhe rapid planned capacitygrowth and 100% fixed-fee
Aviation StrategyBriefing
April 2001
0
5
10
15
20
25
30
Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4
US REGIONALS: TRAFFIC ANDCAPACITY TRENDS
Ann. %change
1999 2000
RPMs
ASMs
remuneration. The consensus estimate isthat earnings will rise by 49% this year, to$1.07 per share, and by 23% in 2002.
After being the fastest-growing largeregional carrier in recent years (36% annual-ly in 1997-2000), ACA has shown that it canhandle rapid expansion. However, integra-tion of the US Airways feeders would poseconsiderable challenges. The purchase, ini-tially valued at $200m, would also weakenan already highly leveraged balance sheet.At September 30, 2000, the company haddebt of $75m, operating leases with a netpresent value of $500m and a planned capi-tal spending of around $800m through 2003.
SkyWestLike ACA, SkyWest benefits from being
linked to two of the strongest majors, Deltaand United, both of which have been happywith its performance. It operates as DeltaConnection in Salt Lake City and as UnitedExpress on the West Coast.
However, unlike ACA, SkyWest still earns30% of its revenues in a pro-rate arrange-ment with Delta, which makes it moreexposed to the economy and fuel prices. Butall of the growth going forward is on a fixed-fee basis, and the share of pro-rate flying isexpected to decline to 10% by 2004.
SkyWest is behind its counterparts in RJutilisation (only 16), but there is substantialgrowth ahead for both United and Delta. Theairline has 114 CRJs on firm order for deliveryover the next four years, plus 119 options forpost-1994 delivery. In 2004 it expects to oper-ate 84 CRJs for United and 46 CRJs for Delta.The plan is to reduce the Brasilia fleet from 96to 65 aircraft over the four-year period.
This rapid move into regional jets wasfacilitated by a mid-January order for 64CRJs plus 64 options for United Expressoperation in Denver and the West Coastmarkets, where currently only two RJs areutilised. This and a recently expanded DeltaConnection contract will enable SkyWest toresume rapid capacity growth this year.
The pilot training and other issues areexpected to be only temporary, andSkyWest's longer-term prospects remainhealthy. Although its per-share earnings are
estimated to have declined by about 6% in thefiscal year ended March 31, the current year'searnings are anticipated to increase by 30%.
MesaMesa has come a long way since its bit-
ter breakup with United three years ago. Ithas recovered financially, restored opera-tional performance and won back the confi-dence of its codeshare partners. Aftersteadily expanding its longstanding relation-ships with America West in Phoenix and USAirways along the East Coast and in theMidwest, the carrier recently received confir-mation that United would honour its USAirways Express contract.
Mesa and United reached agreement todrop all outstanding litigation and to extendthe current US Airways contract by twoyears to 2010, subject to the merger takingplace. Although the deal merely confirmedMesa's current allocation of 36 RJs, analystsbelieve that the carrier, with its substantialRJ orderbook, is well-positioned to gainmore growth opportunities with United.
Under the expanded America West con-tract, Mesa will operate 43 additional region-al jets (currently 22), including three CJ-200s, 20 CRJ-700s and 20 CRJ-900s. The700 and 900 series deliveries will begin inearly 2002 and 2003 respectively. The deal,which also provides for a higher profit mar-gin in turboprop flying, facilitates continua-tion of 20%-plus annual capacity growth untilthe middle of the decade.
The intention has been to dedicate allEmbraer ERJs to US Airways (or United)Express and all CRJs to America West byearly next year. The turboprop fleet isexpected to decline further from 118 to 52aircraft or less by the end of 2002.
Since 40% of Mesa's revenues still comefrom pro-rate operations, the carrier is moreexposed to a weakening economy thanother regional carriers. Nevertheless, its per-share earnings are expected to increase by24% in the current fiscal year (to September30) and by 37% next year. Like SkyWest,Mesa is steadily expanding the proportion offixed-fee flying as its RJ fleet grows andmore turboprops are retired.
Note: * = Forecast. Source: OECD Economic Outlook, December 2000. **Euro rate quoted from January 1999 onwards.1990-1998 historical rates quote ECU. *** = $ LIBOR BBA London interbank fixing six month rate.
AIRCRAFT AVAILABLE FOR SALE OR LEASE
JET AND TURBOPROP ORDERSDate Buyer Order Price Delivery Other information/engines
ATR -Airbus Mar 22 Khalifa Airways 3 A340-500s,
5 A330-200s, 10 A320s 2004+Mar 19 EVA Air 2 A330-200s 2003 GE CF6-80E1 A3 engines
Mar 2 United Airlines 8 A320s, 7 A319s 1Q2003 IAE U2500 enginesFeb 27 Qatar Airways 2 A380s, 5 A330-200s 2Q2002+ Plus 3 options for A330-200s
BAE Systems Mar 1 British European 12 RJX-100s $360m 2002-2006 Plus 8 optionsBombardier Mar 14 Air Dolomiti 3 CRJ200s $66m 1Q2002 Conversion of optionsBoeing Mar 23 Royal Air Maroc 20 737NGs $1.2bn 2003-2013
Mar 23 Royal Air Maroc 2 767-300ERs 1Q2002Mar 16 Uzbekistan AW 2 767-300ERs 3Q2002
Mar 6 CIT Aerospace 20 737NGs $1.3bn 2003-2006 Plus 5 757-300 optionsMar 6 Air 2000 8 757-200s 2003-2005 Rolls Royce RB211-S35E4 enginesMar 4 Air Berlin 2 737-800s 2002+ Previously unannouned customer
Embraer - Fairchild -
Note: Prices in US$. Only firm orders from identifiable airlines/lessors are included. MoUs/LoIs are excluded.
Aviation StrategyMacro-trends
April 2001
Old Old Total New New Total narrowbodies widebodies old narrowbodies widebodies new TOTAL
Group Group Group Group Total Total Load Group Group Total Total Total Load Grouprevenue costs operating net ASK RPK factor rev. per costs per pax. ATK RTK factor employees
profit profit total ASK total ASKUS$m US$m US$m US$m m m % Cents Cents 000s m m %
Note: Figures may not add up due to rounding. 1 ASM = 1.6093 ASK. *Airline group only.
Group Group Group Group Total Total Load Group Group Total Total Total Load Grouprevenue costs operating net profit ASK RPK factor rev. per costs per pax. ATK RTK factor employees
profit total ASK total ASKUS$m US$m US$m US$m m m % Cents Cents 000s m m %
Note: Figures may not add up due to rounding. 1 ASM = 1.6093 ASK. *Pre-tax. **SAirLines’ figures apart from net profit, which is SAirGroup. ***Excludes Condor from 1998 onwards. 4Q+ data are on IAS basis.
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