How Various Macroeconomic and Financial Risks Influence
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HOW VARIOUS MACROECONOMIC AND FINANCIAL RISKS INFLUENCE CORPORATE STRATEGIC DECISIONS IN THE GLOBAL AIRLINE INDUSTRY A Project Presented to the faculty of the College of Business Administration California State University, Sacramento Submitted in partial satisfaction of the requirements for the degree of MASTER OF BUSINESS ADMINISTRATION in Finance Bernd Hannes Sollfelner FALL 2016 © 2016 Bernd Sollfelner ALL RIGHTS RESERVED ii HOW VARIOUS MACROECONOMIC AND FINANCIAL RISKS INFLUENCE CORPORATE STRATEGIC DECISIONS IN THE GLOBAL AIRLINE INDUSTRY A Project by Bernd Hannes Sollfelner Approved by: __________________________________, Committee Chair Jai Joon Lee ____________________________ Date iii Student: Bernd Hannes Sollfelner I certify that this student has met the requirements for format contained in the University format manual, and that this project is suitable for shelving in the Library and credit is to be awarded for the project. _____________________, Interim Associate Dean for Academic Programs ___________ Stephen Crow, Ph.D. Date College of Business Administration iv Abstract of HOW VARIOUS MACROECONOMIC AND FINANCIAL RISKS INFLUENCE CORPORATE STRATEGIC DECISIONS IN THE GLOBAL AIRLINE INDUSTRY by Bernd Hannes Sollfelner This paper reflects about global and regional macroeconomic conditions represented through Gross Domestic Product (GDP) growth rates, foreign exchange rates, interest rates and commodity price rates, and how those rates must be conditioned that global firms can avoid exit strategies. Furthermore, this paper describes how the two business models of low cost carriers and full service carriers may react in case economic conditions deteriorate, and which exit strategies they might choose to survive. The business model of low cost carriers is defined as being focused solely on flying and competing on low ticket prices, while full service carriers focus besides flying also on offering travelers a wide array of additional services on their airplanes and at airports, they operate. v First, this paper describes economic conditions, which must be in place that firms do not engage in corporate strategies. These economic conditions are characterized to have a strong global growth in gross domestic product, which causes a strong demand to cover higher interest rates, stronger currencies and higher energy costs. Thus, there seems to be this paradox that high oil prices, moderately higher interest rates, and even a strong currency are good conditions for a firm in the airline industry to be profitable, whereas low energy prices, low interest rates, and weak currencies are negative and do not guarantee positive returns for airline firms in the long term. For example, since the Seventies data of growth rates of oil, energy and GDP show that there is a positive relationship between growth rates and oil growth rates as Figure 3: World Growth in GDP, Energy, and Oil demonstrates in the Chapter 3. Therefore, on a global scale including all industry sectors low oil prices are a result of contractions and consequently are not desirable. To the contrary, long-term high profits in the airline industry were achieved during times of high energy prices in the years of 2006 and 2013 (FAA Aerospace Forecast Fiscal Years 2015-2035). Second, this paper gives an overview about the global character of the industry and the differences between the business models of low cost carriers and legacy carriers, which are also called full service carriers, and how these two business models react when economic conditions change. Because airline firms are connecting countries and continents, their services and operations involve selling tickets all over the globe. They vi also incur costs for operating maintenance of airplanes and for airport and air control fees at various destinations in many different countries and regions with foreign currencies. Consequently, airline firms are more exposed to changes in growth rates, foreign exchange rates, interest rates, and commodity prices like oil in different regions of the world than other industries. For example, the economic crisis in Venezuela with hyperinflation caused a problem for American Airlines and Delta Airlines with having unexpected losses in 2013 (Nicas), or natural occurrences like the Japan’s Fukushima disaster of 2011, which effected the German Lufthansa by being pressured to engage in exit strategies through reduction of capacities by using smaller airplanes for flights to Japan (Inagaki). Moreover, low cost carriers are more often exposed to exit markets permanently than Legacy Carriers because of three reasons. The first reason is that they were designed to cover a market to compete, but they were not supposed to challenge full service carriers. However, low cost carriers’ task was to hinder full service carriers becoming monopoly- like carriers with the liberalization of air traffic in the United States since 1978 (Domenico). The second reason is that they are operating mostly on point-to-point routes instead utilizing the extensive Hub and Spoke route systems. Point to point connections are much more vulnerable to new entrances by other new airlines in the market and exposed heavily to economic changes in one or both destinations of such a route. The third reason is consumer behavior. Many casual tourists have converted to low cost vii carriers, while frequent flyers and business passengers still prefer to book through travel with full service carriers (O’Connell). If there is an economic downturn, tourists are more likely to cancel their trips than business travelers. Therefore, low cost carriers operate are more sensitive to cyclical customer demand. Low cost carriers have smaller and inflexible capacities because of their business model of saving costs. To operate with one brand and size of airplanes (Morrell), these firms are consequently more vulnerable to downturns in local markets because they are restricted in adjusting their capacities to changes in customer demand at vacation destinations due to fluctuations in interest rates and foreign exchange rates. Full service carriers though can adjust to new conditions because of their availability of having different sizes of airplanes and the capability of building alliances with other firms through code sharing. Finally, this paper will explain four types of corporate strategies, which are first the permanent withdrawal from any particular routes. The second corporate strategic option is the temporary reduction of capacities by limiting the number of flights on schedules, and the use of smaller airplanes. The third one includes the benefits of mergers and acquisitions to create stronger firms by combing access to various markets and as a result, making the post-integrated firms more attractive to investors and strengthen them to survive from a severe crisis. At last, the fourth corporate strategic option is the building of global alliances to gain worldwide access among airlines. viii Moreover, managements of airlines need also to study forecasts for GDP growth rates in various regions they operate in, because these forecasts will play the ultimate role in making decisions how and when to exit if market conditions change. For example, a management of an airline firm will stay in a market with incurring low profits or losses and defend market shares if forecasts for a region show a healthy economic future and the current crisis is only temporary. However, if a bad situation is expected to be permanent, airlines will exit as soon as possible to cut losses. This paper concludes that GDP growth rates are the most relevant parameters for mangers to decide which one of the above four corporate strategic options need to be considered, while low energy prices, favorable foreign exchange rates or low interest rates are not going to be the determining factors for firms’ corporate strategic choices. _______________________, Committee Chair Jai Joon Lee _______________________ Date ix TABLE OF CONTENTS Page List of Figures ............................................................................................................ xii Chapter 1. INTRODUCTION………………………………………………………………...1 Statement of Collaboration ................................................................................1 Project Purpose .................................................................................................2 Main Project Problem ........................................................................................8 2. BACKGROUND OF THE STUDY ......................................................................20 Literature Review – Project Development .......................................................20 Project Research Questions…………………………………………………..31 3. ANALYSIS………………………………………………………………………43 Economic Environment and the Relationships Between Oil Price, GDP Growth Rate, World Travel Demand, Foreign Exchange, and Interest Rate....43 Two Business Models of Low-Cost Airlines and Full Service Airlines...…... 59 Conditions Leading to Corporate Strategic Decisions....……………….….....64 Corporate Strategic Decisions...………………….………………… ………..81 4. FINDINGS AND IMPLICATIONS……………………………………………...85 Findings and Implications…....……………………………………………….85 x Work Cited ...................................................................................................................91 xi LIST OF FIGURES Figures Page 1. U.S. Refiners Acquisition Costs ………….…………………………………............45 2. World Real Gross Domestic Income ……………….…………………………….…48 3. World