The implications of being one cycle ahead January 1999

Today the world economies have become disconnected; witness the continuing economic boom in the US, the continental European economies lagging the UK’s growth, recession in Japan and disaster in Southeast Asia. And, as the world’s airlines were deregulated at different times, the combined effect is that the US airline industry is one economic cycle ahead of Europe and Europe is one cycle ahead of Asia. So what can the laggards learn from the US experience, and to what extent will the European and Asian industries follow the US model?

Since the deregulation of the US airline industry in 1978, there have been two periods of recession — 1979–82 and 1990–93 — and two periods of prosperity (at least in airline industry terms) — 1983–89 and 1994 to the present. Over the past 20 years the US airline industry has undergone such a vast transformation that it may now be justifiable to describe it as ‘mature’.

The 1st US cycle - chaos

The timing couldn’t have been worse in many respects. One of most regulated and protected industries in the world was suddenly let off the leash by the regulators just as the US, and rest of the world, slid into recession. The downturn in demand resulted in over–capacity, and this in turn allowed start–ups (some low–cost, others not) to enter the market with relative ease. And the result of some 200 start–ups entering the market, competing with the incumbent Majors that were struggling to adapt to the new environment, was chaos.

By the end of the 1980s, however, the airlines had absorbed many of the lessons of deregulation, and had developed the skills and tools needed to manage throughout the cycle. Among the most important of these was a more sophisticated understanding of yield management, the use of frequent flier programmes, the development of hub and spoke systems, consolidation and — perhaps most importantly — a keen focus on costs.

The 2nd US cycle - order

These skills didn’t save the US airlines from massive losses (worse than those experienced in Europe and Asia) in the recession, but they meant that the surviving carriers emerged from the downturn in much improved health.

The Majors have now resumed the consolidation process that began in the previous cycle. If the Continental/Northwest and American/US Airways quasi–mergers are permitted, then the top four airlines in the US accounted for 83% of the market in 1997, up from 64% in 1991.

Even more important has been stability in pricing, brought about by the fact that the disparity in the cost of production has shrunk. The cost differential between benchmark Southwest and the mega–Majors has narrowed significantly: in 1991 the cost per ASM difference between Southwest and Delta was 37%; by 1997 this figure had narrowed to 20%.

The nature of competition has moved from point–to–point basis to network competition through the use of hubs. Consequently hub domination has been a major priority for the mega–Majors. The average market share of the largest airline at the top 10 largest US airports has increased from under 50% in 1990 to more than 60% in 1997.

Another feature of this cycle for the US carriers has been a restrained and responsible approach to ordering new capacity. With carriers no longer aggressively chasing market share, the amount of new aircraft ordered has led to a general improvement in load factors. In 1991 the average load factor of the Majors was 53.6%, by 1997 this figure had risen to 70.9%.

With a more conservative approach to the introduction of capacity and continuing consolidation, the yield environment has hardened. Published business fares have risen strongly according to the American Express index, and in 1997 the lowest discount fares available had risen by 33% in just two years.

A more circumspect attitude towards aircraft ordering has also had a favourable impact on balance sheets. Gearing levels have fallen sharply, credit ratings improved and therefore the cost of borrowing reduced for the Majors. Start–ups, on the other hand, are finding it harder to raise capital and funding, and their market share has dropped to 1.3% of total RPMs. Hence the competitive environment appears to have evolved from cut–throat competition to one of almost happy co–existence. The US airline industry model will, of course, not be exactly replicated in Europe and Asia, but it does provide a framework in which to place the likely developments that will occur in the next cycle.

Europe today - confusion

In the 1980s, the European airline scene was typified by a relatively stable cost, yield and traffic growth environment, which produced reasonably healthy levels of profitability. But only a very few privatised European scheduled carriers prepared adequately for Euro–deregulation; the rest did practically nothing. The discrepancies in cost and product levels were to cause much bloodshed once the regulatory shackles were removed.

The European market is characterised by confusion. Some carriers are profitable (but not as profitable as their US counterparts) and many others, despite the buoyancy of underlying market, are scarcely breaking even. But the natural selection process has not really begun. Government protection in the form of some US$17bn worth of state aid has bought some of the larger flag carriers time, but the next downturn will force the unreformed carriers to downsize, retreat, or perish. But hub and spoke systems are increasing in importance — with Paris CDG, Frankfurt and Schiphol all providing stiff competition to London Heathrow.

The complicating factors

So what are the critical differences between the US market and the evolving European market? First, the US domestic market accounts for nearly a third of world traffic, and therefore for US airlines the most important strategic decision to get right is how to maximise domestic profitability. This was highlighted by the ill–fated attempt of United and Delta to enter a domestic code–sharing agreement. From a non–US perspective, the key question was how would this alliance impact on the Star Alliance and Atlantic Excellence partners. From the perspective of Delta and United however, if the domestic code–share agreement had been consummated, the revenue benefits created would have far outweighed anything that could be generated through their international alliances.

No sizeable carrier outside the US has a domestic market of anywhere near that of the US. Therefore the most important question for the strategic planners of European airlines is to get their international policy correct, and so it has been the Europeans that have been driving the international alliances, particularly across the Atlantic.

Second, cross–border restrictions on airline ownership prevent consolidation. These barriers are particularly strong in Asia, where no real multilateral liberalisation legislation is in place. However, the Asian economic crisis has caused rapid change: Singapore Airlines’ attempt to purchase 30% of China Airlines and Cathay Pacific’s proposed acquisition of a stake in PAL are a sign that the consolidation phase may have started.

In Europe, the consolidation phase is underway. EU carriers can now own other EU carriers, the only complication being the protection of bilateral agreement for airlines wishing to operate outside of the EU itself. If this hypothesis is right, then the next upswing should be far more profitable for the European airlines than the current upswing. And if airline alliances continue apace alongside consolidation then the first decade of the next century, regulators permitting, could represent a golden era.

The 3rd US cycle: re-regulation?

US market maturity has resulted in the concentration of power in the hands of the few. The last of the mega–Mergers are probably over — United and Delta was seen as a step too far. The question with the current level of concentration is whether the mega–Majors will win the public relations battle that network competition gives the consumer the best combination of choice, service and most importantly price. If the airlines fail to win that argument then the next US cycle may be dominated by the re–regulation of the industry.