Sky News Online reported that Sir Richard Branson’s Virgin Atlantic Airlines is assessing various merger and/or tie up proposals. While there is no formal process underway, US carrier Delta Air Lines is rumored to be among the interested. Sky News City editor Mark Kleinman has learned that “Delta's interest, while at an early stage, may have gone as far as recruiting investment bank Goldman Sachs to advise it.”
Just last week, I was addressing the ACI-NA International Aviation Issues Seminar on the very topic – that we should expect to see a serious push, and hopefully a meaningful discussion among stakeholders, to consider changes to the archaic restriction that limits foreign ownership of airlines. Whether or not this Virgin – Delta story has merit, I am confident that it will not be the last headline we read regarding tie-ups of airlines with different nationalities in the coming years. The motivations for mergers or tie ups with various airlines will vary depending on strengths and weaknesses of the carriers involved.
The financial case for this merger activity is quite compelling. In my presentation, Emerging Markets and Evolving Models: Challenging the Industry’s Structure, I questioned whether the alliance structure is the best operating model to compete with the emerging airline models in Latin America, the Middle East or China.
Some Numbers for Context
Consider earnings. In 2010 the global airline industry is expected to report a $15 billion profit. While impressive in absolute terms it represents net earnings of 2.7 pennies for each one dollar in revenue. This is paltry when compared to other businesses that earn on the order of 6-7 cents and more for each dollar of revenue. Even with a slow recovery underway, profits for the industry are forecast to decline by 40 percent in 2011, which means that industry earnings are forecast to fall to 1.5 cents for every dollar of revenue generated. Surely 2010 is not as good as it gets?
Such slim profits cannot support the 1,500 or so airlines out there for long. The industry simply needs to be able to consolidate shares of a disparate and a highly fragmented global structure just as steel and autos and shippers have done. Those industries would certainly not be happy earning 2.7 cents on the dollar if that was as good as it gets.
It is not the mature economies that are expected to grow at high rates, but rather the emerging economies in Asia, the Middle East, Africa and Latin America. Moreover, it is the emerging airline models serving these regions that are certain to pose serious threats to iconic names like Lufthansa, Air France/KLM, Alitalia, Air Canada, British Airways/Iberia and the alliances of which they are members.
Just as there is consolidation activity within the US and European airline industries primarily, traffic is consolidating around and among the largest metropolitan centers on the global map. Competition for this traffic is already vigorous. Strong brands and strong balance sheets will be required to mine this traffic. Can alliances be brands? I think not given the large numbers of airlines that make up these alliances.
According to Airbus, Asian demand is highly concentrated around 11 points on the map: Tokyo, Osaka, Seoul, Beijing, Shanghai, Taipei, Hong Kong, Bangkok, Kuala Lampur, Singapore and Jakarta, with nearly half of the demand in the Asian-Pacific market traveling between these cities and 91 percent flying to and from these cities. Given the rapid growth of the low cost carriers in Asia and the Middle East carriers targeting traffic from each of these points, it is clear that individual carriers cannot possibly compete with the emerging low cost juggernauts. So the next question becomes whether the alliances as they now stand could do so either?
Just as capturing and retaining connecting traffic is driving consolidation activity in Europe, flow traffic is the necessary ingredient in making the Middle East airline model work. The geographic advantage to the Middle East carriers to compete aggressively for global flows is staggering. Within 2,500 nautical miles of the region lives 36 percent of the world’s population and 16 percent of the world’s GDP. Within 4,500 nautical miles lives 86 percent of the world’s population and 63 percent of the world’s GDP. Move the distance to 8,000 nautical miles – the distance where new aircraft technology can and will fly – and the world is virtually captured on a one-stop basis. North American and European carriers cannot make the same claim.
Today, Emirates’ route map alone covers Asia, Europe, China, the Middle East, the commodity-rich African continent and Commonwealth of Independent States. Ethiad and Qatar serve many of the same points as well. Will the Middle East airline models under construction be the catalyst for the first global airline merger?
A Financial Case for Global Mergers
Why can industries that serve the airline industry consolidate – often across borders – and the airlines cannot?
- Air Traffic Control: One per country
- Aircraft Manufacturers: Two to four providers with 95+ percent market share
- Aircraft Leasing Companies: Two providers with 45 percent market share
- Global Airline Industry: More than 1,500 providers. Top 10 have less than 40 percent market share
- Ground Handling: Less than three providers at deregulated airports
- Catering: Top two providers have 40 percent market share
- Airports: Arguably are natural monopolies
- Maintenance Repair Organizations: Top five companies have 50 percent market share
- Global Distribution Systems: Top three providers have 85 percent market share
The global airline industry’s response to limited foreign ownership has been to create more and more elaborate relationships with partner airlines. In the "Alliance Phase", we have gone from interline agreements to special prorate agreements to sales incentive agreements to codeshare and blocked seat arrangements to the free sale of code sharing. Today the industry has evolved into an "immunized joint venture phase" either sharing profits or revenue. Assessing the level of synergies that can be realized by either a JV or an outright merger, a joint venture only captures 50 percent of the financial potential.
Alliance relationships capture more than two-thirds of the revenue potential from new domestic and intercontinental origin and destination traffic. The alliance JV’s capture nearly 70 percent of the benefits to be derived from the frequent flyer plan. But the JV mines very little in terms of cost synergies, arguably deriving only 20 percent. In addition a merger would permit a full network redesign that would benefit both the revenue and the cost sides of the equation.
While it is true that the size of the three alliances is increasing, the top five carriers in each alliance drive the strong majority of the synergy benefits. The four immunized JV STAR alliance carriers generate 75 percent of the traffic share across the North Atlantic; the immunized JV carriers in SkyTeam garner more than 85 percent of the North Atlantic traffic; and the immunized JV carriers in oneworld are expected to carry nearly 100 percent of that alliance’s traffic.
Branson Has Reason to Explore His Options
The North Atlantic market is now hyper competitive as all three alliances have anti-trust immunity. And while Virgin Atlantic is unaligned at this point, I can make a case that Virgin Atlantic’s value increased after AA and BA were granted the ability to form an immunized transatlantic joint business agreement. Why? Just like there has been a mad scramble among the three alliances to bolster their respective competitive positions at New York and Tokyo, London cannot be ignored given its importance on global airline map. And Virgin has slots and a meaningful presence at London’s coveted Heathrow airport.
When you think about it, oneworld is in no position to increase its share of slots at LHR without inciting the envy of its rivals and the harsh scrutiny of regulators, while STAR has British Midland’s slot holdings through Lufthansa. That leaves SkyTeam. Delta has been exhibiting a thirst for new Heathrow flying from Miami and Boston (both important oneworld markets). Delta has also enhanced service to Heathrow from each of its important gateways at New York, Atlanta and Detroit. But there is only so much Delta can do on its own at LHR. And there is only so much SkyTeam can do given its slot portfolio.
SkyTeam does not need a hub at London as it already has two of the finest connecting hubs on the European continent in Amsterdam and Paris Charles deGaulle. In order to compete fully, airlines need to be able to sell on both sides of the ocean. Assuming that there is a modicum of truth to the Delta-Virgin Atlantic rumor, a Delta play at Heathrow is no different than what has been taking place in New York/Newark and Tokyo over the past year. London’s importance in each alliance’s portfolio is no different.
Singapore Airlines owns a 49 percent share of Virgin Atlantic. Singapore and Delta have had a long relationship, with both carriers having a cross 10 percent equity stake in a prior life. Or, Branson may be feeling like he would like to monetize some of his 51 percent holding given the changed competitive dynamics taking place across the North Atlantic and the new and potential competition coming from the Middle East. Imagine if he were to sell an equity piece to a Middle East-based airline?
The United States and the European Community still have the ownership issue to negotiate per Phase II of the original US – EU Open Skies Treaty. The Europeans are interested in expanding the ownership levels while the US wallows in labor and Defense Department concerns. In the past, the US has played catch up with global metamorphosis. Now is the time to be proactive, not passive, as competition from the Middle East gains ground.
- If vendors serving the airline industry are allowed to consolidate into dominant positions with few border restrictions, and . . .
- If other industries like steel are permitted to consolidate market power around 4 global providers, and . . .
- If the global airline industry has not one dominant player, and . . .
- If Joint Ventures only capture 50 percent of potential synergies, and . . .
- If the five biggest alliance members produce 60 percent of the benefits, and . . .
- If the new and emerging competition is obvious,
- Why should airlines be hamstrung in their ability to maximize financial performance?
- Why should airlines be forced into Band Aid solutions like alliances when new and emerging competitors are building truly seamless, organic and homogenous products?
- Why should companies that are, or are certain to be, under attack from new competition be prohibited from joining hands to mount the strongest possible competitive reaction?
A far flung alliance formation has less chance to build a global brand than the new and emerging competition. Imagine a day when the carriers involved in today’s JV schemes are allowed to invest in one another and use the equity capital to homogenize service offerings.
Imagine a day when decades old protectionist thinking gives way to an understanding that the airline industry is a global industry. Imagine a day when US flag carriers are able to adapt their business plans to the reality that the business is not domestic but rather how the domestic market interacts with the international market?
Imagine . . .