The airline CFO's headaches May 2001
Hot on the heels of the announcement of the largest corporate loss in Swissair’s history (see Aviation Strategy, April 2001), the group’s CFO, Georges Schorderet spoke at the IATA Financial Conference in New York at the beginning of April. He was speaking under the title of "Major Concerns and Decisions of the Airline CFO".
He started off by outlining the big problems. An airline has a large number of stakeholders in the business with vastly differing requirements and effects. The basic stakeholders under the European plan are the employees, customers, and providers of finance. The customers provide the revenues — through a mixture of the volume, price and quality. Employees, highly unionised, create the largest pressure on costs through labour charges. Shareholders want their return on investment. Finance houses want their pound of flesh — but unlike other stakeholders will have security. In addition however, he suggested that there were other stakeholders in the game.
Suppliers, such as the airline manufacturers, computer reservation systems, travel agents and fuel vendors all have an interest in the survival of the airline, their customer, but want to ensure that their services attract the highest price possible. Furthermore, governments and airports (not always separable) require the airline to exist but impose almost unnegotiable costs of airport charges, overflying charges, ATC charges, traffic right restrictions, concessions and delays.
Looking back over the past decade, the IATA airlines have seen operating revenues rise by an annual average 5.6%, while yields have fallen by an annual average 1% and unit costs have declined by an annual average 0.8%. The industry, as we all know, is cyclical but since the introduction of the jet in the 1960s has never achieved an operating profit in excess of 6% in any one year.
The third source of cranial pressure arises from the profile of an airline’s profit & loss account. For the average European airline, 85% of all revenues are directly related to traffic generation — with 75% coming from passenger services and a further 10% from cargo operations. These of course relate to the short term aspects of the business, are directly dependant on the economic environment and over which the airline has minimal control. Importantly the "product" has an extremely short shelf life — once the aircraft door is shut, you cannot fit another bum on a seat. The remaining 15% of revenues are on the whole more stable, relating to maintenance, catering and other services — although these are revenues that offset the costs of operations that most carriers regard as essential parts of their core business.
On the cost side, 63% of costs are now effectively long term and inescapable in the short run (although some of these cost categories may have some variable elements). These relate to staff costs, aircraft ownership costs, fuel costs and the catch–all "other". Therefore, Schorderet suggested that the average cost of distribution at 18% of total revenues (or costs) was the area that could provide the largest source of improvements to the bottom line.
However, Aviation Strategy is not convinced that that huge improvements in financial fortunes can be made from the reduction in distribution costs. As we are already seeing, as soon as any carrier changes its distribution strategy in any one market, its competitors follow suit. An airline that is dominant in any one area can more afford to undercut the competition in the commissions it pays to agents — but equally cannot afford to do so in areas where it has below average market share.
As for the new distribution methods, each has access to the same technology. In the end, when the internet actually is providing the conduit for the majority of airline booking, the cost of distribution will become more and more of a zero sum non–competitive game, and as usual the airlines will return to the customer the savings they make. In the end, it may be personnel costs and the wonderful "other" that provide the greatest cost and profitability differentiation between carriers.
Airlines make the lowest returns in the wider industry. The airline operator is only one of the links in the air transport chain. It is also as a whole the weakest link, and the one that provides the lowest rate of return on capital.
Indeed over time, it is the one element of the wider industry that does not provide returns in excess of its cost of capital. The providers to the industry (the aircraft manufacturers, airline lessors and the airlines) all have a relatively high cost of capital relating primarily to the volatility and cyclicality inherent in the business.
However, there are only two manufacturers and four major lessors. In contrast, there are hundreds of individual airlines in direct competition, despite the globalisation trend into a handful of alliances wit world–wide reach. In complete contrast, the services (ground handling, catering, airports and reservation systems) have a far lower average cost of capital, but all make superior returns. In each case, the competition is very limited.
When any business makes returns lower than its costs of capital it is destroying value. The CFO has to focus on all areas of the airline operations with the aim of value creation — which vary from the very long term to the day–to–day worries. This is to ensure that the balance between the cash flow returns over time and the capital employed in the business are sufficient to provide excess cash returns over the weighted average cost of capital.
He has to ensure that the right long–term decisions are made for the structure of the business: the right aircraft at the right times and on the right financial basis; the right set of alliances; the right portfolio of businesses. He has to be involved in the management of the "Human Capital". He has to concern himself with the product, service and quality of output. In the short run he has to manage the risks effectively — currency, fuel, and interest costs — to ensure that the airline survives and creates value through each separate cycle.
To achieve the ultimate aim of value creation and a cash flow return on assets exceeding the WACC, the CFO has to juggle the drivers. Business operations can be split into basic operating drivers: Variable cost and fixed cost elements, which will determine the operating margins; gross assets, stock, creditors and debtors which determine the asset turn; volume and price realisation which determine the revenue growth.
The financial drivers of operating margins and asset turns determine the value driver of cash flow return on investment (CFROI). Asset turns and revenue growth determine the value driver of growth. The primary value drivers of CFROI are growth, asset base and the position of the business on the S–curve of its maturity. It is the combination of these value drivers which determine the success in achieving a satisfactory cash flow return.
The aspirin or placebo
Any business in effect has a portfolio of businesses and interrelated operations. Some of these do provide returns in excess of the cost of capital and therefore create value. The business decision should be to close the value destructive elements of the business. Schorderet admitted that in Swissair’s case the business decision to expand by acquisition of minority stakes in other airlines was severely, near fatally, flawed — it had increased significantly its asset base in businesses that destroy capital without having the necessary control over the investment.
The logical conclusion from his speech was that the Swissair Group would dispose of its nonperforming investments and — although he did not quite go that far -- that it should sell or close Swissair and just run the ancillary businesses of catering, maintenance and duty free. If only sufficient numbers of carriers could make that decision, it would fulfil the value chain requirement of reducing competition to allow returns to improve to a point where the industry as a whole can create value.