LEAVING THE RED Creating a profitable airline

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1 Despite airline industry growth over decades, the majority of airline businesses remain consistently unprofitable over an entire business cycle. - Ganna Demydyuk, Choosing financial KPI in the Airline Industry LEAVING THE RED Creating a profitable airline Air travel has been under significant pressure from many directions the past decades. Although the market has grown significantly, positive margins are rare and the classic players in the industry are being challenged by new innovative companies. Still, some companies are actually making profits. Many of them are American, while European airlines, with some exceptions, are struggling to make ends meet. This white paper looks into what makes an airline profitable, and possibly, what the slow performers can do to increase their profits. Contents Steady Growth > Decreasing Cost Base > The Top Performers > The Valuable Ancillaries > The Profitable Airline (Conclusion) >

2 Year-on-year % growth White Paper Steady Growth For many years, air travel has grown steadily. More people than ever before are using air as a means of transport. Flying, that in the early days was considered glamorous and limited to a selected few, has become a possibility, often a necessity, for most people in the developed world. Looking back 20 years, we see an average growth rate of 5%. With the exception of some major dips in the general economy, the growth has been quite steady, especially when it comes to carrying passengers. Moreover, GDP growth and growth of air travel seems highly correlated. Looking closer at the financial collapse in 2008/2009 and the subsequent recovery, the relationship between GDP and air travel seems clear. Growth of air travel and air freight Freight (FTK) growth Travel (RPK) growth 20-year average growth rate The growth rate of air travel has been steady around 5%. Airline indiustry ROIC and world GDP growth Airlines ROIC World GDP growth Airline ROIC seems to follow the world GDP.

3 Trying to accelerate faster than GDP growthrate also seems to have a direct effect on profits. During 2015, American domestic airlines increased available seat miles (ASM) at a higher rate than expected GDP. This immediately showed up in compromised yield. The same is now happening in the Middle East and Africa, where available capacity is exceeding GDP growth. If history repeats itself, this will lead to challenged profits and possibly a need for consolidation as reality catches up. Decreasing Cost Base Although new financial arrangements regarding the planes have had positive effects, airlines typically have a high fixed cost base. Like all others in the logistics business, they are also highly exposed to fluctuations in oil price. Aside from these, labour obviously makes up a significant cost for the airlines. Oil prices have sunk dramatically. Although now on a careful rise again, the they are still half of what they were a few years ago. Taking that into account, one would assume that profits in air travel should have risen. Let s again go back in time and look at margins over a longer period. In the diagram below, cost and revenue per tonne kilometer for air transport is compared over time. Cost related to revenue closely related.

4 Even though temporary fluctuations in cost may occur from time to time, they have not really provided any sustained increases in profits. Even after the deregulation and subsequent emergence of challengers in the air travel market such as the low cost carriers, it would seem the airline industry experiences close to perfect competition. Changes in the cost base seem to almost immediately be reflected in the price, which persistently holds profitability back. A major challenge to airline profitability is the commoditized nature of the product. It is very difficult to sustain any competitive advantage over a typical airline seat. However, the rise of unbundled fares and the addition of ancillary services is starting to change the airline product and allowing a more differentiated service. This is also starting to show a positive effect on profitability. Changes in the cost base seem to almost immediately be reflected in the price, which persistently holds profitability back. The Top Performers So, is it impossible to run a profitable airline? Even though the industry in general is performing quite poorly, especially in comparison with margins in other industries, there are some airlines that are actually turning a quite healthy profit. Not only are many of these airlines showing significantly higher profits, they are also taking market share from others. Aside from some low-cost carriers in Europe and Asia, these airlines are typically found in the United States.

5 North American profits soar above the rest of the world. What makes an airline profitable? In the case-study Choosing financial KPI in the airline industry, researchers found that operating profit per passenger or passenger kilometer seems to be the most significant variable in explaining variations in airline profitability. Looking closer at the top performers, they have focused heavily on some key elements: direct distribution faster turn-around times lower cost of labor new planes with lower fuel consumption Aside from these cost-oriented efforts, additional revenue from ancillary services seems to drive profits for the top performers. Many have gone above and beyond in unbundling their fare and recovering revenue from the ancillaries. The graph below shows the correlation of profit and share of revenue that is made up of ancillaries. Airlines with a higher proportion of ancillaries typically having better operating margins. Share of ancillary revenues drives operating profits.

6 The Valuable Ancillaries The year 2015 is, according to most researchers, a record year for air travel. On average, IATA estimates that airlines are making just over USD 8 per passenger. When looking more closely at where that profit is made, it seems ancillaries are having a significant impact. Most carriers have realized the value of ancillaries as a natural consequence of the macro trend of unbundled fares for a long time. The issue that now remains is that the majority of a carrier s ancillaries are only available through their own web sites. Post-tax net profit per passenger. This chart from Amadeus indicates the points of sale for airlines globally. Although there may be variations in different regions, it is clear that a majority of sales channels are not the airline s own web site. Getting the full inventory of ancillaries available in the reseller channels still remains a major issue. Consequently, one of the most profitable revenue sources available for an airline is only offered to 35% of the market. Where the airline revenues come from. Source: Amadeus.

7 The Profitable Airline Conclusion While cost and load factor will continue to be crucial for airlines, increasing revenue per passenger should be a key addition. Although seemingly gloomy at times, air travel should have a potential of eventually becoming more profitable. The growth of low-cost carriers offering unbundled products, complemented by an á la carte menu of ancillaries, suggests that passengers want to buy air travel this way. Many of the more recent low-cost airlines have shown impressive growth and sustained profitability. Solving the issues of more efficient and content-rich distribution for traditional full-service carriers may help develop profitable revenue streams. In a world where eight US dollars is regarded as an all time high, selling a meal or the possibility to select your favorite seat for a few extra dollars will have huge impact on the profit potential of tomorrow s airlines. Perhaps more than that of saving a few dollars on operational cost, as these savings tend to be more or less immediately reflected by the fare prices. Sources IATA Economics, Airline Financial Monitor, Ganna Demydyuk, Choosing financial KPI: the Airline Industry case, May 2011 Oliver Wyman, Airline economic analysis, Economic Performance of the Airline Industry, Mid year 2015 forecast presentation, June 2015 Svend Olav, VP Industry Affaris at Amadeus, Seminar in Helsinki January, 2016 Planestats.com About Paxport Paxport generates revenue for airlines and travel resellers by managing their travel merchandising and passenger data. As an IATA NDC Strategic Partner, we enable clients to capitalise on emerging travel-retail opportunities. MORE ABOUT PAXPORT >