Aviation Economics & Finance Professor David Gillen (University of British Columbia )& Professor Tuba Toru-Delibasi (Bahcesehir University) Istanbul Technical University Air Transportation Management M.Sc. Program Module 3: 23 November 2015
OUTLINE Module 3 (2 hours) Aspects of Airline Finance Airline Cost Classification Assessing performance Investment appraisal and financial evaluation Risk management (foreign currency / fuel price / etc.) November 23-28 3
AIRLINE COST STRUCTURE November 23-28 4
UNDERSTANDING COSTS Accounting profit: Total Revenue-Total explicit cost Not just difference in cash inflows and cash outflows out but value of assets generated by business activity less asset value lost due to business activity Economic Profit: = Total Revenue Total Expenses (explicit expenses + opportunity cost) Time value of money Cost categories versus cost behaviour Accounting assigns cost based on a view to cost responsibilitywhere the cause of a cost originates Cost causality based on underlying cost behaviour with respect to some variable(s) November 23-28 5
WAYS OF THINKING ABOUT COSTS Broad categories Startup costs Production costs Fixed costs Variable costs Marginal costs Detail of Explicit Costs Selling and general administrative expenses Fuel costs Flight & cabin crew costs Direct maintenance expenses Landing fees and capital equipment charges Distribution costs (sales & promotion) Station costs Ground expenses Passenger services Interest expenses Taxes November 23-28 6
Startup costs COSTS THE DETAILS Costs incurred to begin a business or service a portion of which are generally (but not always) sunk sunk cost fallacy Production costs What resources are used up in order to produce a product or service Joint/common costs and assignment what is the opportunity cost of a air marshal? November 23-28 7
Fixed costs COSTS THE DETAILS CONT D Costs that do not change when the amount or rate of output changes These costs are not avoidable ; e.g. aircraft ownership Semi-fixed no significant change over a broad output range happens with lumpy inputs (e.g. gates) In aviation FC are large Variable cost Cost varies as output varies; e.g. fuel, labour, materials & supplies Some variable costs are semi-variable, again due to lumpiness November 23-28 8
COSTS RELATIONSHIPS Total costs TC) = Fixed cost (TFC) + Variable cost (TVC) Average Total Cost (ATC) = AFC + AVC Airline types of costs: CASM = TOTAL COST/ASM CASM OPERATING = OPERATING COST/ASM Marginal cost = MC = ΔTC = TC TC or = ΔQ Q Q i E.g. Aircraft catering Costs as f(airplanes catered) TC, FC, VC, AFC, ATC, MC MORE ON COSTS AND DETAIL ON TUESDAY November 23-28 9
AN EXAMPLE WITH AIRCRAFT CATERING COSTS AIRCRAFT CATERED TC FC VC AFC AVC ATC MC 0 $200,000 $200,000 $0 $0 $0 $0 $0 1 $300,000 $200,000 $100,000 $200,000 $100,000 $300,000 $100,000 2 $400,000 $20,000 $200,000 $100,000 $100,000 $200,000 $100,000. 12 $1,400,000 $200,000 $1,200,000 $16,667 $100,000 $116,667 $100,000 November 23-28 10
WHY MIGHT COSTS VARY Factor prices Productivity Taxes/Public policy Costs are a product of factor hired x factor productivity (VMP or MRP) November 23-28 11
SOME EXAMPLES OF DIFFERENCES IN CASM Source: Oliver Wyman, Airline Economic Analysis (November 2014) November 23-28 12
SOME EXAMPLES OF DIFFERENCES IN CASM Source: Oliver Wyman, Airline Economic Analysis (November 2014) November 23-28 13
COSTS THE DETAILS FIXED COSTS Fixed salaries & benefits, and crew training do not vary with aircraft usage Maintenance costs labour & contracted services costs of annual inspections Leased costs based on time Depreciation Operations overhead Administrative overhead Self-insurance costs VARIABLE COSTS Crew costs (travel, overtime, wages of hourly staff) Maintenance costs based on hour usage of assets (aircraft) or flying cycles Labour, parts, contracts, engine overhaul Modifications Fuel and other fluids Lease costs based on flights hours Landing fees and airport and enroute charges November 23-28 14
Operating Costs (OC) Direct OC Flight crew Aircraft fuel and oil Airport fees Navigation charges Direct maintenance: labour & materials Depreciation/Rentals/ Insurance: Flight equipment ANOTHER FORM OFCOSTS BREAKDOWN Non-operating Costs (NOC) Depreciation Interest Insurance Losses from retirement of property Losses from affiliated companies Other loss items (e.g. foreign exchange) Indirect OC November 23-28 15 Marketing Ground property & equipment o Depreciation, insurance, maintenance Administration & sales o Services administration o Reservations & sales o Advertising & publicity o General Servicing o Passenger services o Aircraft services o Traffic services
WHY MIGHT COSTS & CASM VARY ACROSS AIRLINES Differences in stage length Differences in seating density Differences in Productivity November 23-28 16
HOW STAGE LENGTH PLAYS A ROLE Source: Oliver Wyman, Airline Economic Analysis (November 2014) November 23-28 17
Source: Oliver Wyman, Airline Economic Analysis (November 2014) November 23-28 18
HOW SEATING DENSITY PLAYS A ROLE Source: Oliver Wyman, Airline Economic Analysis (November 2014) November 23-28 19
Source: Oliver Wyman, Airline Economic Analysis (November 2014) November 23-28 20
Source: Oliver Wyman, Airline Economic Analysis (November 2014) November 23-28 21
PRODUCTIVITY-PERFORMANCE Partial productivity metrics Total factor productivity (TFP) Operational performance indicators November 23-28 22
KEY STRATEGIC PERFORMANCE INDICATORS (PARTIAL) Source: IATA November 23-28 23
FINANCIAL PERFORMANCE INDICATOR: REVENUE & COSTS November 23-28 24
OPERATIONAL KEY PERFORMANCE INDICATORS Fuel cost efficiency Staff Productivity Employment costs November 23-28 25
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STAFF PRODUCTIVITY November 23-28 27
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OTHER PERFORMANCE INDICATORS THAT COULD BE TRIED Daily utilization by aircraft type Direct operating expenses per flight-hour Direct operating expenses per aircraft Flight operating expenses Maintenance and Overhaul Expenses per flight hour Fuel & Oil Expenses per flight hour How do we handle connecting flights? IS CASM more straightforward than RASM? November 23-28 30
MEASURING AND MANAGING RISK November 23-28 31
WHERE IS THE RISK? Make a distinction between risk (unknown) and uncertainty (measurable). Risk-we don t know what will happen but we know the distribution Uncertainty we don t know what is going to happen and we do not know the distribution. Just as an investment portfolio has an expected return so does a network of flights Think of the expected return on a network as n E N = w i ρ i k i i=1 where w is the importance or weight of route i in the network and is the probability that an outcome will occur (e.g. state of the economy for route r and k is the return on a route (or a flight) November 23-28 32
MANAGING AND MEASURING RISK Variance = 2 = E N = σ n i=1 w i ρ i [k i k i ] 2 that is there is a difference between the actual and anticipated return. Standard deviation,, is Variance St. dev associated with normal distribution In a normal distribution 68% of all measures fall within 1 st. dev of the mean, and 95% fall within 2 st. dev of mean. November 23-28 33
DIFFERENT STANDARD DEVIATIONS November 23-28 34
EACH PROCESS (ACTIVITY) HAS A RISK DISTRIBUTION Basic airport processes: Curbside, check-in, security, boarding, airside infrastructure services Ancillary services: sources of non-aviation revenue Basic airline processes: Decisions within the airline (see next slide) Infrastructure provision (airport services, ATC) Exogenous influences: weather, politics, SARS, war Risk tolerance: Safety 0 tolerance On-board services risk averse November 23-28 35
STYLIZED AIRLINE PROCESS MAPPING November 23-28 36
BETA MEASURE OF RISK In stock returns beta is a risk measure that describes the relationship between an individual security expected return to that of the market. Use the same idea to express the relationship between the expected return from an individual route and the return in a network or region. β i = cov k i, k n σ 2 k n Where n is network or you could use a region Beta is used to calculate WACC November 23-28 37
NEED TO KNOW BETA Source: Sheelah Turner and Peter Morrell (2003), An evaluation of airline beta values and their application in calculating the cost of equity capital, Journal of Air Transport Management,9, 201-209 Check multiple sources, different sources give different numbers Beta is backward looking, based on past events but should adjusted to reflect risk profile going forward. unlevered-value of if firm had no debt levered by using s projected debt/equity ratio November 23-28 38
BETA AND WACC β unlevered = β current 1 + (1 t) D E actual β levered = β unlevered 1 + (1 t) D E target WACC t = k d 1 t D V + k ps PS k d is cost of debt (i rate on bonds) k ps is cost of preferred stock k e cost of common equity (common stock, retained earnings) t is effective tax rate D is market value of debt E is market value of equity outstanding V + k e e V Where does enter? November 23-28 39
Industry Number of firms Beta D/E Ratio Tax rate Unlevered beta Cash/Firm value Unlevered beta corrected for cash HiLo Risk Standard deviation of equity Air Transport 22 0.98 81.51% 18.71% 0.59 3.63% 0.61 0.4971 53.32% Auto & Truck 22 1.09 105.95% 4.45% 0.54 7.78% 0.59 0.6152 43.52% Banks (Regional) 676 0.53 77.69% 20.66% 0.33 12.56% 0.37 0.1969 37.41% Beverage (Alcoholic) 22 1.06 21.88% 8.54% 0.88 1.66% 0.89 0.5838 55.14% Business & Consumer Services 177 1.19 30.41% 13.30% 0.94 5.17% 1.00 0.5382 52.77% Computer Services 119 1.16 27.56% 10.48% 0.93 5.64% 0.99 0.5193 59.41% Electrical Equipment 126 1.24 16.86% 5.99% 1.07 6.52% 1.14 0.5870 65.34% Entertainment 84 1.21 27.52% 4.11% 0.95 3.26% 0.99 0.6339 58.48% Green & Renewable Energy 26 1.32 109.96% 1.94% 0.63 6.10% 0.68 0.7017 53.18% Healthcare Products 261 0.99 15.67% 6.73% 0.86 4.54% 0.90 0.5028 64.48% Machinery 137 1.23 20.43% 15.64% 1.05 5.94% 1.11 0.4598 46.22% Paper/Forest Products 22 0.84 51.02% 11.54% 0.58 3.25% 0.59 0.4571 44.94% Restaurant/Dining 79 0.89 27.87% 15.14% 0.72 2.35% 0.74 0.3574 44.43% Retail (Automotive) 30 1.18 50.19% 18.76% 0.83 1.34% 0.85 0.4353 48.06% Retail (General) 23 1.03 31.37% 21.36% 0.83 2.68% 0.85 0.3159 46.36% Shipbuilding & Marine 14 1.36 53.62% 6.75% 0.91 3.49% 0.94 0.4613 71.45% Steel 40 1.31 64.03% 13.99% 0.85 6.31% 0.90 0.3778 52.45% Transportation 21 0.86 21.03% 20.08% 0.73 4.11% 0.77 0.3829 42.36% Transportation (Railroads) 10 1.05 20.21% 21.30% 0.90 1.76% 0.92 0.3456 30.73% Trucking 30 1.32 66.66% 27.38% 0.89 2.72% 0.92 0.3604 48.49% Total Market 7887 1.06 66.14% 10.76% 0.67 4.95% 0.70 0.4697 53.60% November 23-28 40
BROADER VIEW OF RISK MANAGEMENT Source: easyjet 2014 annual report November 23-28 41
END OF MODULE 3 November 23-28 42