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
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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
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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
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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.
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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
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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
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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.
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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
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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
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LIST OF FIGURES Figures Page
1. U.S. Refiners Acquisition Costs ………….…………………………………...... 45
2. World Real Gross Domestic Income ……………….…………………………….…48
3. World Growth in GDP, Energy, and Oil.………………………………………...... 49
4. World Passenger Demand…………………………………………………….……..51
5. World Air Carrier Profit/Loss …………………….…………………...………...... 53
6. US Dollar Currency Index...…………………...………………………………...... 56
7. Domestic Revenue Passenger Miles and Market Shares..………...…………...…….63
8. Economic Growth Rates in Various Regions of the World in 2015..……………….65
9. World Real Gross Domestic Product Forecast.…….………………………………..76
10. U.S. Real Gross Domestic Product Forecast....……………………………...………77
11. U.S. Refiners Acquisition Cost (Rate)....……………………….…………………...78
12. U.S. Refiners Acquisition Cost Forecast 2015-2035………………………………..79
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1
Chapter 1
INTRODUCTION
Statement of Collaboration
I would like to thank Professor Jai Joon Lee for suggesting to work on this project, which
combines aspects of financial and strategic global management. The idea for this project
was demanding because of finding the right industry, which best describes the relationship between: energy prices, interest rates, foreign exchange, and regional and global GDP growth rates, and how managements of two basic business models either focused on costs or on value might react to global and regional economic downturns choosing four different corporate strategic decisions. However, it was also an incredibly
rewarding experience because I was challenged to prove how my ideas and suspicions are
valid and defendable. I am grateful for Professor Lee’s help putting these ideas onto paper to finish this project. I also want to thank Ariella Sollfelner and Valerie Lewis for
their assistance to edit this paper.
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Project Purpose
The purpose of this paper is to emphasize that businesses are acting in an increasingly global environment, which demands global strategic thinking and acting. Therefore, the idea of having no interest whatever happens in other parts of the world is becoming progressively inadequate and dangerous for businesses’ long term survivals. Therefore, problems in global financial risks in different regions like North America, Latin America,
Europe, and East Asia need to be recognized, and economic forecasts of diverse regions must be analyzed to navigate firms safely through times of global integration to fulfill a firm’s purpose to produce profit. If global firms want to be successful, they need managements to evaluate if the foreign market they are pursuing is worth staying in or exiting. Otherwise economic conditions of those markets change or even deteriorate.
Furthermore, different business models are suited for different customer segments and markets; they react differently to changes in business environments. Consequently, this paper points to ways how global firms engage in four different corporate strategies when they are forced to react to regional and global recessions.
One of the best examples for a business exposed to global risks is the airline industry because this industry is global by nature. The international airline industry provides services to virtually every corner of the globe and has become a tool for creating a global economy. The airline industry itself is a major economic force, both in terms of its own
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operations and impacts on related industries such as aircraft manufacturing and tourism
(Global Airline Industry Program).
Global airline companies are exposed to macroeconomic risks such as changes in energy
prices, growth rates of regional and global Growth Domestic Products, foreign exchange
rates, and interest rates. Therefore, the airline industry was chosen for this paper to show
how these four risks define the economic environment and determine if corporate strategic decisions have to be implemented by the management to protect their companies from net losses losing market shares and ultimately from bankruptcies. These corporate strategic decisions are: exiting a regional market, temporary reducing capacities, merging and acquiring other firms, and joining alliances to adapt to deteriorating economic environments. In conjunction with those four corporate strategic decisions, the question arises if those energy prices, GDP growth rates, foreign exchange rates and interest rates are of equal value or if there is a hierarchical order of risks to be considered by management. Additionally, if such risks exist, which of those four risks are the most important to management in considering the execution of global strategic decision.
Macroeconomic risks. The first risk is the GDP growth rate, which measures the economic growth from one period to another as a percentage rate adjusted for inflation.
This rate measures the health and growing potential of different markets, but also the whole world. Using the supply and demand theory (Dutt), airlines will increase supply to satisfy increased demand in such markets through expanding presence, frequency, and
4
capacity. However, they will also exit or reduce their capacities if markets contract
through lower demand because of sluggish, low, or even negative growth rates.
The second risk is the foreign exchange rate, which exists when financial transactions are
denominated in a currency other than the base currency of a company. Thus, the demand for a currency increases as well as its supply. Therefore, markets with higher valued currencies also increase profits for businesses operating from outside those markets. If a
currency increases its value, airlines operating outside of this market will increase their
profits in the market of a stronger currency. While this is happening, airlines of a market
with a strong currency will face lower profits or even losses. However, airlines from
strong currency areas can still make profits through looking for alternatives (outsourcing maintenance, call centers, ticket sales, etc.) to those markets with weaker currencies to reduce costs.
The third factor is the risk of interest rate changes. Markets with higher interest rates are usually the one with higher GDP growth rates because they follow the demand and supply theory. This theory describes that investors will invest in regions, where they can earn higher profits (Dutt). Regions with higher GDP growth rates also experience higher demand for goods and services. To satisfy higher demand, the airlines in the growing regions with moderately higher interest rates purchase larger amounts of more powerful
airplanes than airlines in regions with low interest rates.
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The forth risk is about changes in energy prices. Using again the supply and demand
theory: if the demand is strong, the price and the supply increases and consequently more
gas is produced (Dutt). Thus, a low gas price is primarily a result of low demand and stagnant world GDP growth rates (figure 3). This paper will show that even though
current gas prices are very low and high net profits of airlines are achieved in the short
run, revenues of airlines are decreasing for 2016 as the IATA fact sheets show.
Therefore, the airline industry is not growing as the frequency of flights is stagnant and
the levels of capacity are unchanged. In the long run, this situation will cause that airlines
will face problems of over capacities, lower revenues, and increased price competition.
Moreover, airlines were profitable during years of high oil prices during the years of
2006 and between 2010 to 2014 even though thirty percent of all costs are energy related
in the airline industry (Genovese). Subsequently, despite the common belief high gas
prices seen as negative, high energy prices are positive for the economy because they are
the result of higher demand caused by GDP growth.
Two business models. Starting in 1978 with the Airline Deregulation Act in the United
States, global airline deregulations created an environment where now two fiercely
competing dominant business models have been established worldwide. The first model
operates based on low cost strategies with focus on price, one kind of airplane, point to
point routes, and casual tourists as customer base. However, the second model’s strategy
is based on full service and focuses on value, the availability of different capacities
through variety of airplanes, hub and spoke network, and business customers. For
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example, in 2005 only 14 percent of available seat miles were provided by low cost
carriers in Europe (O’ Connell); however, in 2016 Ryanair, the Irish low cost carrier, is
now the biggest airline in the European Union. This example shows how rapidly the
airline industry changed in the last twenty years. A similar situation occurred also in the
United States. Since 2015 the low-cost carrier Southwest Airlines is the biggest airline by
revenue in the United States (FAA Aerospace Forecast Fiscal Years 2016-2036).
Another purpose of this paper is to illustrate how these two business models are targeting two different kinds of customers. One side shows that low-cost carriers are targeting casual leisure customers, who tend to use the airline services infrequently to popular tourist destinations, prefer point to point connections, and buying tickets several months before their departure. The other side shows business passengers, who are flying frequently and purchase their tickets very shortly before departure. One third of full service customers are employed by large firms, which have at least more than one thousand employees (O’Connell). Most of these business travelers (with a company corporate travel policy) also prefer to travel from the central big hubs like New York’s
JFK airport, London Heathrow, or Frankfurt because of their connectivity to access car rentals and transfers to primary hotels. Those passengers react differently to economic downturns because business people will always fly to a lesser extent, while tourists will postpone or cancel their vacations. Therefore, the choice of exit strategies between the two businesses models is different.
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Corporate-level Strategies. Finally, the final purpose of this paper is the description of
four kinds of corporate-level strategies, which are strategic plans and subsequent actions
of management to enable firms to survive difficult economic situations. These four
strategies are permanently leaving the market, temporarily lowering capacities, creating
mergers and acquisitions during bankruptcies, and joining global and regional alliances.
If a certain point to point connection changes demand or a competitor with a better cost
structure enters a market and engages in price wars, incumbents without any possibilities
to restructure their costs will engage in a strategy of leaving the market and lose completely the market share (Dixit). This strategy is performed by both low-cost carriers and full service carriers.
The second corporate strategy of lowering capacity is mostly performed by full service carriers. To keep market share, it is primarily full service airlines that engage in a strategy of lowering frequency of flight schedules or using smaller capacity airplanes. To perform this exit strategy, firms need a variety of airplanes and have enough financial resources to be able to stay in a market despite the risk of loss.
The third corporate strategy of merging and acquiring other airlines is not only performed when firms are in trouble, but also for acquiring firms to gain market share. This corporate strategy makes it possible to create bigger airlines with wider market shares, to withstand difficult economical situations with ease in the future, and open the newly acquired markets.
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Finally, joining alliances helps airlines to save costs and to keep and capture new market
shares. Firms are less vulnerable to economic difficulties because capacities can be
adjusted by flying specific routes and sharing those and airports for those routes with
separate airlines. Therefore, airlines joining alliances are also able to offer their customers better connections by using multiple airlines to get to their destinations as well as creating more convenience for purchasing tickets.
Main Project Problem
While the airline industry exhibits vulnerability with its inability to foresee external events (volcanic ashes, terror attacks, epidemics and pandemics like Ebola or SARS), this paper will focus primarily on macroeconomic issues regarding the volatility of oil prices, domestic and world-wide GDP growth rates, foreign exchange rates, and interest rates. It will also focus on the characteristics of the two business models of low-cost carriers and full service airlines. Furthermore, this paper will also include the issue of corporate strategies such as exit strategies. Overall the focus for this paper centers on strategic corporate decisions in search for surviving positions in the turbulent economic environments.
There are three distinctive problems facing the airline industry. The first problem describes how economic environments can get worse considering three factors. These
9 include the relationships between energy prices and GDP growth rates, fluctuations in the foreign exchange rates, and interest rates. The second problem discusses how firms of the two business models are reacting to changes in the economic environment globally and regionally. Finally, the third problem involves what actions of low cost airline managements and full service carrier managements take when they are facing such problems in the economic environment.
Commodity prices and GDP growth rates. One major problem to describe the economic environment is the relationship between GDP growth rates and energy prices. Moreover, the airline industry is even more exposed to this problem because the airline industry’s single main cost is fuel. Around 30 percent of all costs related to airlines are fuel-related expenditures (Genovese). Therefore, it could be assumed that the main factor to make operational profits would be dependent on the oil price. However, despite an oil price of
$54.7 per gallon the world air carrier operating profit was only 1.9 billion US Dollar in
2009 (FAA Aerospace Forecast Fiscal Years 2015-2035). In 2013 at a gas price of 100.8
US Dollar per gallon the world air carrier operating profit was at 25.3 billion US Dollar
(FAA Aerospace Forecast Fiscal Years 2015-2035). A similar situation also happened between 2002 and 2007. The gas price went from 20 US Dollar in 2002 to nearly 80 US
Dollar in 2007, while in 2002 the global airline industry had a net loss of 11.3 billion US dollars. However, in 2007 the global airlines achieved a net profit of 12.9 billion US
Dollars (FAA Aerospace Forecast Fiscal Years 2010). Obviously, there are other factors
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responsible to achieve profitability than energy prices. These factors will be the global
GDP growth rate, foreign exchange rates and interest rates.
If the GDP growth rate is stronger than the demand for energy; then, the oil price will
increase. If the global growth rate is low or even negative, energy prices fall. In late 2008
the oil price fell from 101.5 US Dollars per barrel by almost half to 54.7 US Dollars per barrel in 2009 (FAA Aerospace Forecast Fiscal Years 2015-2035). In the same year, the global growth rate was at negative 1.7 percent. A year later the global growth rate was at
4.3 percent and the oil price raised to 74.9 US Dollar per barrel. Therefore, the global growth rate determines the price of energy, consequently, low energy prices are a result of low GDP growth.
Because changes in energy prices indicate a dependency upon GDP growth rates, and there seems to be a relationship between interest rates on the one side, energy costs and
GDP growth rates on the other side. At the beginning of the recent Great Recession of
2008, the Federal Reserve set the fund rate between 0 and 0.25 percent to kick start the
U.S. economy which was suffering from negative GDP growth rates. While the growth
rate in the United States improved slowly during the years after the Great Recession,
China’s growth rate reached a GDP growth rate of 10 percent in 2010. Moreover, China’s growth rate pushed up even the global GDP growth rate to 4.3 percent, which hyped up oil prices to levels of over 100 US Dollar between 2012 and 2014. However, since 2010 the global growth rate has descended to the level of the U.S. growth rate of 2.4 % (FAA
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Aerospace Forecast Fiscal Years 2016-2036), and the Japanese, the Swiss and the
European central banks implemented even negative rates to boost their economies. Thus, the oil price decreased to lower levels than during the recent Great Recession with an average oil price of 48 U.S. dollars in 2015 compared to 54.9 US Dollar per barrel in
2009 (FAA Aerospace Forecast Fiscal Years 2015-2035).
Thus, national governments, which are dependent on commodity prices such as the emerging markets in Latin America and Russia, are facing negative growth rates when commodity prices fall. For example, the sinking commodity prices in countries like
Brazil, which experienced a negative growth rate of 3.2% for 2015 (FAA Aerospace
Forecast Fiscal Years 2016-2036), and other countries in this region, such as Venezuela and Argentina are facing stagflation, hyperinflation, and political unrest. Consequently, this situation causes revenues for airlines operating in those regions to be currently negative because of sinking demand of travelers despite low fuel prices. Consequently, the question for many international airlines operating in this region arises if it is still feasible to stay and operate in those markets.
Foreign Exchange rates. The next big factor for analyzing the condition of the economic environment is the observation of fluctuations in the relationship between foreign exchange rates. As the fluctuation of the US Dollar Currency Index (DXY) shows, a currency’s value is dependent on the strength of economic growth where the currency is used. In the case of the US Dollar, if the economy is poor in the United States the US
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Dollar comes under pressure and is lower valued against the other main currencies like the Euro, the Yuan, the Japanese Yen, etc. (Marotta). In general, the relationship between currencies works properly only if all currencies are equal, and all goods and services can be purchased in all currencies; however, this is not always the case.
For example, oil is typically purchased in US Dollars, which grants the US Dollar the role of a dominant global currency (Oxley). Thus, U.S. firms have a strategic advantage, which leads to higher profits for U.S. airlines than any other airlines in the rest of the world because oil is typically traded in US Dollars. This creates the problem that a rising
U.S. Dollar diminishes profits for firms outside the United States because they need to exchange their currencies into a stronger US Dollars prior to the purchase of fuel. To the contrary, U.S. airlines can take full advantage of lower oil prices. Because of this economic imbalance, the foreign exchange market is distorted.
Another problem with foreign exchange fluctuations is hedging against perceived exchange rates of foreign currencies. Huge losses of companies are often the result of hedging against a certain currency moving into the opposite direction despite the general outlook. This scenario happened to the South African airline SAS in 2002. Prior to that year, SAS hedged against a rising US Dollar because the general world-wide belief was based on forecasts that the value of the US Dollar would rise for the foreseeable future.
However, it turned out that the value of the US Dollar decreased because of the dot.com
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burst and the terror attacks of 9/11/2001. SAS only survived through a government bailout the following years (Triana).
Interest rates. Firms in the airline industry are facing problems with interest rates when
they consider to expand or renew their fleets. On one side, low interest rates make it
easier to purchase and lease airplanes, but on the other side regions with a high demand
will also have higher GDP growth rate. Therefore, investments occur in regions with
higher growth rates despite higher interest rates. Furthermore, investors prefer to invest in regions where higher returns can be earned. Currently, the rate of the Chinese Central
Bank is set at two percent, while the growth rate is at 6.5 percent. However, the Fed’s fund rate is between 0.25 and 0.5 percent while the United States growth rate is at a mere
2.4 percent (Global-rates.com). Despite higher interest rates in China, Boeing is investing strongly and is selling 300 airplanes and building a completion and delivery center for future Boeing 737 airliners. Globally, this order has been the largest airline order ever worldwide (Cameron). Consequently, moderate higher interest rates are the product of higher GDP growth rates, and investors put their capital to work where there is demand and higher returns are expected. Therefore, there appears a contradiction, that moderate higher interest rates are positive for growth in an economy despite the common belief that low interest rates are necessary for boosting GDP growth in low growth economic environments.
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Low cost and full service carriers. The second group of problems concerns the characteristics of the two different business models of low cost and full service carriers.
The low-cost carriers have been very successful over the last thirty-eight years. For
example, in 2005 only 14 % of available seat miles were provided by low cost carriers in
Europe. Currently, Ryanair, the Irish low cost carrier, has become the biggest airline in
the European Union surpassing Deutsche Lufthansa (O’Connell). In the United States,
Southwest Airlines had also the greatest amount of success as a low-cost carrier and has
become the biggest airline by revenue since 2015 (FAA Aerospace Forecast Fiscal Years
2016-2036). These two facts demonstrate how successful the business model of low cost
carriers has become, and how it has transformed the whole airline industry globally.
Low-cost carriers follow a business model of simplicity, efficiency, productivity and high
utilization of assets (Morrell). Firms following this business model also compete with
low fares to conquer market shares. The distinction between low cost carriers like
Southwest Airlines or JetBlue in comparison to legacy carriers like Delta Airlines or
Deutsche Lufthansa are the development of a brand focused on offering low fares. These
low-cost airlines offer a simplified fare structure and generally sell online tickets, while
legacy carrier firms are focused on the value of services by providing rental cars, shuttles
to hotels, hotel reservations, etc.
Airlines following each of these two business models target two different kinds of
customers with two different consumer behaviors. There are leisure customers, who are
15 flying infrequently to destinations where tourists prefer point to point connections and would rather purchase their tickets several months before departure. Alternatively, there are business passengers, who fly frequently and purchase their tickets very shortly before departure. One third of full service customers are employed by companies, which have more than one thousand employees with a company (O’Connell). These business travelers possess a company corporate travel policy and prefer to travel between central big hubs such as New York’s JFK airport, London Heathrow, or Frankfurt because of their connectivity to the major centers of city limits. In addition of easy access to car rentals and services for transferring passengers to primary hotels, these airline passengers react differently to economic downturns because business people will always fly even though to a lesser extend in difficult economic times. On the contrary, casual leisure customers will postpone or cancel their vacations altogether. Therefore, corporate strategic decisions would be different between the two businesses models.
Corporate strategic decisions. The third group of problems summons how macroeconomic events, which affect full service and low-cost carriers evenly, lead their managements to consider corporate strategic decisions differently. There are four different kinds of corporate strategies: a permanent exit strategy, a strategy of temporary capacity reduction, a strategy of merger and acquisition, and a strategy of forming global alliances.
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Permanent exit strategies are the result of fierce competition in weak markets. In the past,
the problem was that low-cost carriers were still profitable in weak markets, while full
service carriers more often faced the possibility to exit and consequently left those
markets. However, after low-cost carriers are now dominantly operating in these markets,
they are now increasingly also more exposed themselves to this fierce competition.
Nevertheless, full service carriers face similar fierce competition in markets of economic
distress. Although labor costs are low in countries in economic distress, revenues in these
markets are also low because of the low purchasing power of the local population and unfavorable exchange rates to the US Dollar. The developing problem of reduced business activity to full service carriers, which are primarily engaged in scheduled flights and focused on business passengers, results in a decline in revenues and profits.
Consequently, the demand for business travels would be reduced and could cause an airline to permanently exit the market.
Nonetheless, if destinations in the same weak markets are attractive tourist destinations, the demand for the segment of point to point destinations rises because of the increased purchase power of foreign tourists in those regions. Airlines with a low-cost carrier business model tend to benefit from such situations because of the fast turnaround time, cheap air fares, selling less tickets in the destination country, and their focus on just flying because the customer behavior of leisure travelers is to spend the money at the destinations for hotels and sightseeing tours (O’Connell). Therefore, any consideration of
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exit strategies by low-cost carriers from such markets can be abandoned because
revenues created by tourist passengers can easily outpace the overall losses in the
destination market.
The corporate strategy of temporary capacity reduction is used, when the condition of a
market is poor; yet, economic forecasts are good. The problem is that this is a corporate
strategy that gives low cost carriers a disadvantage. Consequently, this corporate strategy is frequently used by full service airlines rather than low-cost carriers, which they follow the policy of having only one kind of airplane. For example, Southwest Airlines is using
only airplanes of the type of Boeing 737 airliner. This purchase strategy gives low cost
firms the advantage to purchase or lease more airplanes of the same kind to a lower price.
Additionally, this also reduces maintenance cost, training costs, and makes ticket sales
easier to conduct. However, flying into riskier markets and the high probability of having
excessive capacity per flight hurts low cost carriers more than full service carriers
because capacity cannot be reduced by just flying smaller airplanes as full-service
carriers can do. For example, Deutsche Lufthansa and other full service airlines used
smaller planes on their flights to Japan after the nuclear power plant catastrophe in
Fukushima in 2011 (Inagaki). However, if the market is improving, low cost carriers will
be out of the market, while full service carriers will gain market share in a potentially prosperous market in the future.
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The corporate strategy of merger and acquisition is used by some managements during
the prolonged times of low interest rates and hard competition by low cost carriers.
During the economic downturn after the burst of the tech bubble and the terror attacks of
September 11, 2001, all American legacy airlines engaged in the exit strategy of mergers
and acquisitions. Typically, low interest rates cause problems for funding adequate
pension funds by the airlines because those funds will not generate enough revenue to
cover the costs for paying out pensions without the ability to increase contributions to
cover the losses in the pension funds. Combined with low revenues, net losses will put
airplanes into storage as expansive idling inventory (Morrell), many of these American
legacy airlines went into bankruptcy protections and used corporate strategies like
mergers and acquisitions with other airlines in creating stronger airlines to exit out of
bankruptcy and create strong companies to survive any future economic downturns. The
following examples of mergers and acquisitions strategy were the bankruptcies of Trans
World Airlines in 2001 and US Airways in 2002. Both airlines merged and filed for
bankruptcy in 2011, and were later acquired by American Airlines. Ultimately, they exited as part of American Airlines Group in 2013. Another bankruptcy involved Delta
Airlines. This firm exited bankruptcy in 2007 after merging with Northwest Airlines, which also declared bankruptcy prior to the merger (Adler). These bankruptcies were devastating for many retired employees because their pensions were cut or disappeared completely, causing financial hardship and bitterness for those retirees.
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During this time, legacy airlines in bankruptcy protection had to cut frequency and
density of their networks, thus, creating the result of losing market share and suffering
from excessive capacity. Airplanes needed to be idled, possibly incurring additional new
costs. However, this situation made it possible for low cost carriers with less overhead
costs to establish more destinations on major hubs, as well as empowering them to
become an even stronger competition to full service airlines.
The corporate strategy of global alliances is a reaction to globalism and is mostly used by the management of full service airlines. Global airlines face the problem of not having
the capacity to fly to every destination and serve all their customers on a global basis.
Therefore, alliances like Oneworld, Sky Team and Star Alliance were formed to give
each other airline’s customers global access. For example, a customer of Lufthansa, as a
Star Alliance member, also has access to the network of Singapore Airlines, another Star
Alliance member Airlines. Therefore, travelers can take advantage by booking airline
tickets by dealing with just one office. Switching between airlines on intercontinental
flights with layovers can be done with one ticket. Furthermore, if there are delays and
passengers are missing connections, alternatives can be booked easily and traveler’s
delays can be drastically reduced from days to hours.
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Chapter 2
BACKGROUND OF THE STUDY
Literature Review – Project Development
Economic Environment. To define the condition of economic environments, global firms
need to analyze data about fuel costs, growth rates and the demands from different
markets in order to make adequate decisions for successful outcomes. The report, FAA
Aerospace Forecast Fiscal Years 2015-2035 by the Federal Aerospace Agency, provides
forecast data for the price of fuel, GDP growth rates in various global regions, capacities
like the number and size of airplanes in the United States, forecasts of oil price, global growth, and the passenger demand until 2035. The forecast data provide managers with additional help of making decisions in considering corporate strategies whether to leave
or not to leave from certain markets permanently, or to stay in a weak market if the five
year forecast shows positive data regarding the growth rate. Such forecast can also trigger
mergers and acquisitions if the economic environment is deteriorated or if global
alliances are needed to reduce competition by increasing services for their customers and
profits.
However, the report, FAA Aerospace Forecast Fiscal Years 2016-2036, corrects some of
the results of 2014 regarding net income and growth rates in GDP worldwide. The
21
worldwide growth rate sank from 4.3 percent in 2010 to 2.4 percent in 2015, which is
now the same as the U.S. rate. Therefore, worldwide demand is reduced and creates
additional pressure on price of oil and forces the central bank in Europe and the bank of
Japan to introduce negative interest rates. The same report also predicts that the oil price
will be lower than predicted the year before. Therefore, forecasts can change and the
strategies need to be adjusted to the new environment. However, after 2016, the price of
fuel will be expected to increase to levels between 120 and 140 US Dollar in 2024 as
predicted in 2015. Thus, the long-term forecasts did not change and the global firms will
not need to change their long term corporate strategies.
Mario Genovese shortly lists all risks in the aviation industry in his article “Overview in the aviation risks.” One of these risks is about change of oil prices and the exposure of the airline industry to fuel costs. Considering that thirty percent of all costs of typical airline firms are related to fuel (Genovese), many analysts think that a low oil price will benefit corporate profits. These net profits were high for 2015, as data published by the
Fact-Sheet of the International Air Transportation Association (IATA) (Fact-Sheet-IATA
2016). Despite this situation characterized by low energy costs, high profits in the
airline industry were mostly reached during periods of high energy prices like in the years
of 2006, 2007, 2013, and 2014, as reports of the Federal Aviation Agency of 2010, 2015
and 2016 prove. Meanwhile airline firms suffered record losses during periods of low the
oil prices such as during the years of 2002 (FAA Aerospace Forecast Fiscal Year 2002-
2012), late 2008 and 2009 (FAA Aerospace Forecast Fiscal Year 2015-2035). During
22
2015 when the oil price had bottomed at 30 US Dollar, Air Berlin PLC & Co.
Luftverkehrs KG had reported a net loss in the second quarter although the oil price was
down by 60 percent as reported by the article “Airline Financials,” which was published
in Air Transport World on September 1, 2015. Therefore, low energy prices alone are not a guarantee for higher profits, and other factors must be considered to assess the health of an economic environment.
Furthermore, Aasim Husain and his staff wrote in their report “Global Implications of
Lower Oil Prices,” published by the International Monetary Fund in July 2015, that the authors were surprised about the fall in oil price and blamed it primarily on too much supply that was caused by higher production of shale oil in the United States. This report also expresses the hope for higher demand to outpace the losses in the oil producing countries. However, this article did not mention that at the same time the global growth rate managed to change from 4.3 percent in 2010 to 2.4 percent in 2015 (FAA Aerospace
Forecast Fiscal Years 2016-2036); therefore, higher supply and weak global demand for
energy put strong pressure on oil prices. This creates the situation where sufficient
demand exists to avoid fallen oil prices.
Amitava Krishna Dutt affirms in his study “Aggregate Demand, Aggregate Supply and
Economic Growth” that GDP growth is the single one important factor to determine the
health of an economy because it is the result of demand. Despite the belief of many
economists that demand is only important in the short run but not important in the long
23 run, Dutt proves empirically that this belief is wrong. Therefore, there must be sufficient demand that leads to higher growth rates to make an economy grow. As a result, GDP growth rate is a sufficient measurement to compare with the different economic conditions.
Doug Cameron in his Wall street Journal article “Boing in Deal to Sell 300 Jets to China” describes the biggest deal in aviation history so far to have been made in 2015 between
COMAC and Boing. He also describes that the demand for airplanes in China is huge and the forecasts project e higher demand of 6,330 jets over the next 20 years. Despite a recent economic downturn, China is expected to grow about 6.5 percent GDP growth rate in 2015 (FAA Aerospace Forecast Fiscal Year 2016-2036). Additionally, when considering the low interest rate of 0.5 percent and 2.4 percent growth rate in the United
States, and 1.8 percent growth rate and negative interest rate provided by the European
Central Bank, Boeing is investing in a market with higher interest rates. The Chinese central bank has a rate of 2 percent. Therefore, Cameron’s article proves that higher growth rates are more important than low interest rates for a healthy economy.
This negative idea of low interest rates is again confirmed by the situation of Delta
Airlines in 2004. Nicole Harris described how interest rates influenced the performance of Delta Airlines’ pension funds. Her article “The Economy: Delta Trims Loss to $327
Million, as Airline Industry Slowly Recovers” describes how a drop of interest rates during the fourth quarter of 2004 caused Delta a record charge of 1.1 billion US Dollars
24
to pension obligations. Consequently, in 2005 Delta Airlines went into bankruptcy
protection.
Besides interest rate risks, other financial risks involve values of currencies and
fluctuations among currency exchange rates. The US Dollar Currency Index shows the
relationship of the value of the US Dollar against other global currencies like the
Japanese Yen, the British Pound, the Euro and other currencies. David John Marotta
explains in his article “What is The US Dollar Index?” how the US Dollar mirrors the
recessions and booms in the United States (Figure 6). For example, the US DXY’s lowest
rating of 74 was reached during the crisis in 2008, while the highest rating of 140 was
reached during a strong expanding economy during the eighties. Therefore, the value of
the US Dollar increases when the growth rates are high, while consequently the value of
the US Dollar turns negative when growth rates are low in the United States.
Global firms, which are exposed to the risks of foreign exchange rates, try to protect
themselves from unfavorable changes through hedging. Pablo Triana describes in his
article “Hedging is not riskless” a case of foreign exchange risk. South African Airways
(SAA) decided to enter long-term plain vanilla currency forwards to hedge its exposure to the U.S. Dollar derived from future purchases for fuel and airplanes because of
expectations of a rising U.S. Dollar. However, after the burst of the dot.com bubble and
the terror attacks of 9/11/2001, the US Dollar weakened against the South African Rand
by almost thirty percent. Consequently, SAS faced unrealized hedging loss of around 850
25
million US Dollar at that time. After the airline’s announcement of temporarily insolvent, the South African government provided monetary guarantees to save SAS.
Nonetheless, in the article “Exposure, Hedging, and Value” by Stephen D. Treanor,
Daniel Rodgers, Daniel Carter, and Betty Simkins explain how investors appreciate
hedging by firms in the airline industry because hedging reduces risks of sudden changes
in energy prices and foreign exchange rates. Therefore, investors are more likely to invest
in firms like Southwest Airlines or Ryanair, which engage very heavily in hedging
against fuel costs, because those firms are valued as less risky. Thus, those firms are
highly valued.
According to the above articles, studies, and reports it appears that global airlines can perform well with healthy profits, especially if the economic environment has higher energy costs, moderately high interest rates, and stronger currencies. Consequently, it seems that low energy prices, low interest rates, and weaker currencies are not desirable because they are the result of weak growth rates. Therefore, this creates further problems for global firms to operate and press airlines to consider exit strategies.
Two Business Models of Low-cost - and Full Service Carriers. Clayton and Hirz explain
in their article “Efficiency and Attitudes” the nature of the airline industry that the fierce
competition between low cost carriers and full service carriers causes low profitability.
Historically, airlines of both business models achieve a maximal three percent profit
margin globally.
26
Furthermore, Fabio Domanico explains the theories about the causes for the fierce
competition in his publication "The European Airline Industry: and Economics of Low
Cost Carriers." He bases his findings on the core theory and the contestable market theory, which is also characterized as a “hit and run” competition. He also explains the background, how government authorities liberated the market in 1979 in the United
States, in Europe during the nineties and in Asia during the early two-thousands to avoid monopolistic markets in the airline industry. Continuing the expectations that incumbent airlines would not compete against new formed airlines, which turned to be the opposite and proved the contestable market theory wrong (Domanico).
Peter Morrell’s study “Airlines within Airlines: An Analysis of US Network Airline
Responses to Low Cost Carriers” in the Journal of Air Transportation in 2005
investigates the incompatibility of the two business models of legacy airlines and low
cost carriers. During the late nineties and early two-thousands full service airlines
engaged in a strategy to create low cost carrier subdivisions to better compete with low
cost carriers like Southwest Airlines, JetBlue Airways, or Frontier Airlines. The result
was a disaster. After listing various attributes of low cost carriers as having one kind of
airplane for the whole fleet, focusing more on point to point destinations, the use of
secondary airports, Morrell reports that almost all subdivision airlines failed and
disappeared during bankruptcies, mergers and acquisitions by their parent airlines in the
aftermath of the terror attacks of September 11th, 2001. Moreover, just adapting a
business model based on cost for subdivisions of legacy airlines without lowering overall
27 personal and maintenance costs in the entire airline was not enough to avoid bankruptcies between 2000 and 2007. Thus, Morrell suggests that legacy airlines need to reform themselves first in order to be successful and abandon their low-cost subdivisions.
Obviously, low cost carriers have a different customer base than full service carriers.
“Passengers’ perceptions of low cost airlines and full service carriers: A case study involving Ryanair, Aer Lingus, Air Asia and Malaysia Airlines” by John F. O’Connell and George Williams describes what kind of customers fly low cost carriers, and who travels with full service airlines. There are two types of customers with two different consumer behaviors, which are leisure and business travelers. Leisure travelers are flying rarer and looking for the cheapest deal to save money and spend it for more comfortable hotel rooms, better meals or additional activities at their dream destinations. However, business travelers as frequent travelers are more interested to have additional services like car rentals and hotel shuttles at their destinations. Leisure travelers like to travel in groups, while business travelers travel singularly. Thus, leisure customers use more low- cost carriers, while business travelers, who are flying frequently, are dependent on reliable flight schedules, and search for full service carriers.
However, the customer base for legacy airlines is changing. Nicole Adler and Aaron
Gellman write in their paper “Strategies for Managing Risk in a Changing Aviation
Environment” about the risk for legacy airlines, expressing the change in consumer behavior regarding the lower demand of business travelers because new forms of
28 communication make some business travels obsolete. Therefore, legacy airlines are facing the problem that their customer base is shrinking, and consequently their competitive disadvantages against low cost airlines even increase.
Those changes in the customer base in the airline industry not only have effects in the air but also on the ground. Edward Wong’s article “As Oakland Thrives, San Francisco Cuts
Fees and Courts Discounters” describes the rivalry among three airports in the Bay Area in 2003: Oakland, San Jose and San Francisco International. It also shows how the airports, which were mostly used by full service airlines before September 11, 2001, courted low-cost carriers like Southwest Airlines and their passengers to land at primary airports.
Corporate Strategies. If the economic environment deteriorates in different regions or globally through events like the Big Recession of 2008, firms must change their corporate strategies to survive in such turbulent economic environment. They will consider the following corporate strategies: permanent exits of a route, temporary capacity reductions through flying less frequent or using smaller airplanes to markets with temporarily negative growth rates, creating healthier companies through mergers and acquisitions, and joining global alliances.
First, airline firms' exit behaviors on point to point routes are described in the article,
“Learning and Exit Behavior of New Entrant Discount Airlines from City-Pair Markets” by Ashutosh Dixit and Pradeep K Chintagunta. The authors report that mostly low cost
29 carriers may face exit strategic decisions because they enter markets on beliefs about profitability, which turn out to be not true. Airlines learn about the true market attractiveness over time because their prior beliefs about market attractiveness might not be consistent with the market's intrinsic attractiveness. Furthermore, the possibility of predatory price wars, as Karakaya describes in “Market exit and barriers to exit: Theory and practice,” is one of those problems, which is often not included in airlines’ prior believes. However, Dixit and Chintagunta do not cover exit behaviors of global full service airlines because those airlines are less engaged in point to point connections than low cost carriers, Second, a good example for the corporate strategic decision of temporary capacity reduction is described in the two articles by Jack Nicas “Delta slashes flights to Venezuela” and "Airlines Curb Venezuela Ticket Sales” of 2013 and 2014.
Global airlines decided to reduce their flights to Venezuela because the Venezuelan government has been in distress fighting hyperinflation and stagflation and various supply problems to satisfy its population’ needs since 2012. So, the Venezuelan government chose to renegotiate foreign exchange rates and held revenues from ticket sales of American airlines back and did not let repatriate those funds to the headquarters of these airlines in the United States. Consequently, these two articles describe how individual legacy airlines consider to negotiate with the government about exchange rates, while simultaneously the firms reduce capacities to save market shares to stay in the market because airlines consider this situation as temporary and forecasts for the
South American market between 2016 and 2036 of growth rates are significantly higher
30
than in the United States, Japan, or the European Union (FAA Aerospace Forecast Fiscal
Years 2016-2036).
Another good case for explaining, how this corporate strategy of temporary capacity
reduction works, is described in the article “Many Tourists Cancel Trips to Japan” by
Kana Inagaki. The author reported how mostly Asian customers cancelled trips to
Japanese tourist destinations three weeks after the earthquake in 2011, which caused a
Tsunami and the nuclear disaster of Fukushima. Inagaki describes in this article how
Delta Airlines reduced their frequency of flights by 15 to 20 percent, and how Deutsche
Lufthansa and KLM/Air France reduced their capacities by flying smaller airplanes.
Third, Jin -Soo Lee and Soo Cheong (Shawn) Jang examine the risk of interest rates
versus the health of airline firms in their article of “The Systemic-risk Determinants of
the US Airline Industry.” Furthermore, this study discovered that the bigger the size of a
company the stronger is the capability to withstand economic downturns. Consequently,
after the terror attacks on September 11th, 2001, airlines facing bankruptcy decided to use the corporate strategy of mergers and acquisitions. The website “Airline Industry
Overview” by the Global Airline Industry Program supported by the Massachusetts
Institute of Technology describes the impact of this event on the American airline
industry between 2001 and 2006 (Global Airline Industry Program), which provides
insides why companies were rebuilt through bankruptcies in the years after the terror
31 attack, and how consequent mergers and acquisitions built new companies to withstand future down turns.
Forth, Stephen Leo’s dissertation “Global Airlines: Modeling Profitability and Portfolio for Allocation to International Regions” provides information about the strategy to build global alliances. This strategy benefits airlines, not only through cost reductions in personal and maintenance costs through code sharing, but also their customers by giving them more benefits, such as accumulating frequent flyer miles faster, providing better connections, or buying one ticket for flying with multiple airlines. Besides, airline alliances also give firms better tools to make better offers to customers and reduce competition and enhance profitability. This strategy of joining global alliances, which enables firms to gain market share and to provide physical presence in different regions, where airlines do not have the financial power, infrastructure, personal, and capacity to operate.
Project Research Questions
This paper is based on five questions. Three of these questions are about the economic environment, and the other two are about the two business models and corporate strategies. The first one is: how is it possible for an industry, which uses 30% of all costs for purchasing fuel, to earn higher profits in years when oil prices are high in 2000, 2006,
32
and 2014, but less, when they were low in 2002, 2008 or 2009? The second question is: if a moderately higher interest rate is bad, how is it that the size of aircraft fleets increases in markets with higher interest rates such as in China, whose central bank interest rate is set at more than two percent, for example? The third one is: is an appreciating Dollar positive for growth in the global economy? The forth one is: what are the characteristics of the two business models, which are low cost carriers and full service carriers, and how do they operate in a liberalized market? And the fifth question is what types of corporate
strategies will companies of the airline industry apply when they are forced to look for
exits during a time a deteriorating economy?
Economic environment. The first question is: how is it possible for an industry, which
uses 30% of all costs for purchasing fuel, to earn higher profits in years when oil prices were high for example in 2000, 2006, and 2014, but less, when they were low in 2002,
2008 or 2009? Although the common logic would say that a low gas price should almost always guarantee high profits; the supply and demand theory already suggests that if the demand is stronger, the price is higher, which means that supply must be increased to satisfy demand. This satisfaction of demand means growth (Dutt), which increases the consumption of energy and consequently causes an increase in price. Therefore, the cost of fuel is related to growth rates, which means the higher the GDP growth rates the
higher the oil price. Gross domestic products, which measures a nations or a region’s
output of all services and finished goods, is the only reliable measurement of health of a
country’s or region’s economy. Therefore, if the growth rate is high, demand for goods
33
and services increases, leading to more innovation, more investments, higher demand for
borrowing money, and demand for currencies of booming regions.
Besides, oil prices are influenced by cartels like OPEC and by political conflicts
especially in the Middle East. The report of the International Monetary Fund suggests
that the current oversupply exists because Saudi Arabia is pumping more oil and the shale
oil production in the United States (Husain). However, the global growth rate is also
lagging, which fell from 4.3 percent in 2010 to 2.5 percent in 2013 and 2014 and even to
2.4% in 2015 (FAA Aerospace Forecast Fiscal Year 2016-2036). Therefore, if the global growth rate is strong over the long run, fuel costs will rise as it happened in 1983, 1993,
and 2002- early 2008 (FAA Aerospace Forecast Fiscal Year 2010). Thus, airline
companies are making profits when the demand is high and business and leisure travelers
have money and are enabled to afford mid-range or even long-range travels.
Subsequently, airlines are not profitable, when oil prices are low over the long run.
However, if energy prices fall fast and abrupt as it happened in 2015, companies like
Deutsche Lufthansa AG, Japanese Airlines or American Airlines Group, Inc. are making
high profits over the short run despite flat revenues (Morningstar). Yet, this situation is
only short-lived. When demand stays weak over the long term, profits and revenues will
sharply fall because competition will increase in a stagnant market without growth.
The second question will discuss the issue how a moderately higher interest rate impacts
airlines. How it is that the size of aircraft fleets increases in markets with higher interest
34
rates such as in China, whose central bank interest rate is set at more than four percent?
This issue is like the oil price, the demand and supply theory also influences interest
rates. If there is a strong demand for goods, the demand for loans to finance machinery,
hiring personal, improving infra structure, etc. rises. This means that in regions with
economic growth interest rates are higher; however, on the supply side, more investors
will enter the market to achieve higher returns on their investments.
Consequently, strong growing markets like China or India are attracting more investors
than the regions of the European Union or the United States. For example, the interest
rates set by the People's Bank of China cut its benchmark one-year lending rate by 25 bps
to 4.35 in 2015. Meanwhile, the Federal Funds rate in the United States is between 0.25
and 0.5 percent and the European Central Bank alongside the Bank of Japan reside in
negative territory (Global-Rates.com). Additionally, costs for obtaining loans in regions with low interest rates are lower, the European and American airlines have easier opportunities to obtain loans to increase their capacities through buying newer, bigger, and more airplanes; however, these airlines are not acting on it because there is just no demand for more airplanes.
In 2015 Boeing struck a deal with China that included 300 airplanes and the first aircraft
completion plant in an environment with a higher interest rates of more than 4.3%
(Cameron). Therefore, this investment shows that moderately higher interest rates are a
sign of an economy with higher growth rates, which means airlines must raise the number
35
and size of aircrafts to satisfy higher demand, while in the United States and in Europe the growth of aircraft fleets is rather stagnant despite low interest rates since 2006. To prove this stagnation in the size of aircraft fleets may be shown through these two following facts for the United States. In 2014 U.S. mainline fleets had 3,770 mainline air carrier passenger aircrafts (over 90 seats) and 2,148 regional carrier aircrafts (jets, turboprops, and pistons). In 2007 the U.S. mainline fleets consisted of 3,897 mainline air
carrier passenger aircrafts (over 90 seats) and 2,700 regional carrier aircraft (FAA
Aerospace Forecast Fiscal Year 2015-2035). Thus, there were 127 less mainline air carrier aircrafts and 552 less regional carrier aircrafts in 2015 than in 2007. This situation indicates that low interest rates are not the cause of aircraft expansions.
Is an appreciating Dollar positive for growth in the global economy? This third question
covers the relationship between currencies and how the strength of the US Dollar is
related to the global growth rate. The international Fisher Effect theory suggests that the exchange rate between two countries should change by an amount to the difference between their nominal rates. The nominal rate is the sum of the inflation rate and the
central lending rate. If the nominal rate in one country is lower than the rate in another
country, the currency of the country with the lower nominal rate appreciates against the
higher rate country by the same amount. Additionally, moderate inflation is a sign of a
growing economy. For example, in 2015 the inflation rate in China was just over 2
percent, while the U.S. inflation rate was just at 0.7 percent. Thus, the Yuan depreciated against the US Dollar by .35 Yuan in 2016 (The World Bank). This means, the foreign
36
exchange rate is also dependent on the growth rate, and as a depreciating currency from a
higher level is a sign that the growth rate has diminished and moves towards the
equilibrium. If this currency stays above the equilibrium, that currency’s region will
experience higher growth rates than in the previous one, which is appreciating from a
level under the equilibrium. Currently, the dollar is appreciating; however, the growth
rate in the USA is still low and the current forecast is at 2.4 percent for the following
years till 2035 (FAA Aerospace Forecast Fiscal Year 2016-2036). Therefore, current forecasts indicate that the global airline industry will grow stronger in regions, whose currencies are above the equilibrium like in China and India, than in the United States or the European Union over the next twenty years.
Currently, the GDP growth rate of the United States and the global GDP growth rate are
even and this situation has caused the U.S. Dollar to grow in strength. Under those
circumstances, energy prices will increase in all countries outside the United States
because all energy transactions are typically paid in U.S. Dollars (Oxley). This is a
competitive advantage for airlines in the United States, but a disadvantage for airlines
outside the United States, and if energy prices fall, airlines outside the United States will
not get the full benefit of cheaper fuel prices. Therefore, a strong U.S. Dollar is negative
for the global economy because it is the result of weak global growth and benefits only
the United States. However, the forecast for the next ten to twenty years indicates that the
GDP growth rate in Asia will remain stable, and the GDP growth rate in Latin America
will rebound again to previous 2010 levels (FAA Aerospace Forecast Fiscal Year 2015-
37
2035). Consequently, the value of the U.S. dollar will be reduced, and global growth rates
will increase again.
Low cost carriers and full service carriers. The fourth question is: What are the reasons and results of the airline deregulations starting in 1978? One of the results is that firms of the airline industry follow two business models, which are low-cost carriers and full
service carriers. The first model is focused on reducing costs and targeting leisure
customers, and the second model of full service carriers is focused on offering services
beyond the task of providing flights and targeting often and regularly flying business
customers.
Furthermore, the low-cost carriers cover a niche of the market, where full service carriers
were not present in the past. This market targets a different customer base of travelers,
who are interested in extremely cheap flight prices when it comes to their vacation
destinations, family reunions, or for business travels of small firms.
Since the late seventies through the early nineties, both the United States and the
European Union encouraged liberalization processes in the airline industry, which
fundamentally changed ownership of airline firms. As a result, global airline companies
changed from being government owned and controlled to privately-owned competitive
firms. For example, the formerly German government owned air carrier Deutsche
Lufthansa is currently 100 percent privately-owned. The change in ownership and the
policy of deregulations are the reason why airlines are being managed more effectively
38
today than in past decades. Today’s managements are currently focused on cost
efficiency, operating profitability, and competitive behavior. Furthermore, the management culture of a national governmental agency has changed to one of high
competition with focus on global strategic corporate decisions with the need to decide to
enter or to adapt to business models of being either a low-cost airliner like Southwest
Airlines or Norwegian Air Shuttle or a business class airliner like Delta Airlines or
Singapore Airlines (Global Airline Industry Program).
Nonetheless, this liberalization process in the airline industry started with the justification
by regulators to avoid a monopoly of mostly government controlled and protected firms
with high air fares. However, entry costs like supplementary costs for fees at airports
were evaluated as negligent; therefore, exit costs were not existent. But to the contrary, in
2011 the fixed costs rose to 92. 3 billion dollars worldwide. The current percentage of
fixed costs is at around 15 percent of overall costs (Oxley). This issue shows there is a
strong increase in fixed costs and supplemental costs. Therefore, exit costs are becoming
more prominent in the overall costs, which increase the possibilities of market failures
and lead to a situation of airlines participating in price wars.
The global airline industry continues to grow rapidly, but the consistency of profitability
is still elusive. Measured by revenue, the industry has doubled over the past decade, from
US Dollar 369 billion in 2004 to a projected $746 billion in 2014, as the International Air
Transport Association (IATA) reports. Still the profit margin is still low. Much of that
39
growth has been driven by low-cost carriers, which now control some 25 percent of the
worldwide market and have been expanding rapidly in emerging markets recently
(Clayton).
Corporate-level strategies. The fifth question is, what are exit strategies and how do they
apply in the airline industry? These exit strategies are leaving the market permanently,
reducing capacities temporary, merger and acquisitions after bankruptcies, and global
alliances.
Permanent exits. First, permanent exits occur when firms of the low-cost carrier segment exit because of customers’ preferences or economic downturns or when political circumstances change at a certain destination. Consequently, if a destination becomes undesirable, customers would travel to the next available desirable destination. Therefore, an airline firm must determine if a customer preference is permanently or temporarily dropped or not (Adler). Temporary problems can lead to a decision of staying in the market by using tools of a strategy of temporarily reducing capacities. However, long-
lasting problems will lead to a permanent exit because, despite all possible cost cuts, no
profits can be achieved and long-term forecasts indicate that the economic environment market has no potential for growth.
Second, another reason for permanent exit is competition through predatory pricing. Most firms use price as the main competitive weapon. Predatory pricing is the best-known form of predatory behavior in the airline industry, and it involves lowering prices to an
40
unreasonably low or unprofitable level in a market that weakens or eliminates rival
competitors. Because of price wars, one or more firms are forced to exit the market.
Thus, companies with low market shares will be the first to exit because they have the
least resources to survive (Karakaya).
Third, permanent exit is also the result of poor research before entering a market. Airlines
enter markets often without considering the strength of the competition, overestimation of
own strength to fight price wars, possible change of the local economies at destinations,
and how easy it is for competitors to enter a market (Dixit).
Temporary reduction of capacities. Another corporate strategic decision enforces the temporary reduction of capacities, which is used predominantly by big full service airlines. These airlines have fleets of multiple sizes and types of airplanes, and they also
have the capital to last out temporary losses till the rebound of markets. Therefore, they
can absorb losses to save market share during a limited time. This corporate strategy of
temporary reduction of capacities is used in context with countries and regions with
severe macroeconomic problems as hyperinflation, high deficits of governments and absence of growth as currently experienced in South America and Russia. However, the
Latin American market for example has promising forecasts for having a higher growth
rates than the world’s growth rate (FAA Aerospace Forecast Fiscal Year 2015-2035).
Thus, airlines already in the market try to stay to save their market shares to able to earn
higher future profits. Airlines perform this corporate strategy by flying smaller airplanes
41
as Lufthansa did after the Fukushima disaster in 2011 (Inagaki), or flying less frequent to
destinations like Caracas (Nicas) till the Venezuelan macroeconomic environment
improves.
Mergers and acquisitions. Especially in the early two-thousands, this corporate strategic action of mergers and acquisition was used by legacy airlines in the United States to create stronger firms instead of solely liquidating airlines. These mergers and acquisitions created less competition through having only one or two airlines flying between two destinations. The capacities were better used, and airlines could better access markets through mergers without creating new costs (Morrell).
Global Alliances. The fourth corporation strategic action is forming global alliance
networks. The term for doing so is typically code sharing between different global
airlines. It means that two or more airlines fly the same route at the same departure and arrival times. Global alliance networks have several advantages for firms and passengers.
For instance, firms can stay in markets longer and easier, save capacities and can react faster to changes in demand with the help of partner firms. Another advantage is the increased ability to stay in a market, to protect market shares, and to save costs because ticket sales are administered together, and maintenance and operation is shared as well.
Sometimes airlines may even share human resources with partner airlines to accommodate travelers of different languages on routes between two global destinations
42 by having flight attendants, who can communicate with each group of travelers in their mother tongues.
Other advantages for passengers are the possibility for easier transfers between airlines and accessibility to other networks. Frequent fliers can easily earn their miles for their frequent business travel programs, tickets can be bought for different airlines at one place, and luggage can also handle with speed and ease. One of the major disadvantages is that ticket prices may be higher because of a lack of competition (Leon).
43
Chapter 3
ANALYSIS
The analysis of this project consists of four parts. The first part describes the conditions of economic environments. The content of this part includes how energy costs, interest rates, foreign stock exchange rates, demand and growth rates are related to each other and how they will affect profits in airlines. The second part describes the two business models of low-cost - and full service carriers and shows how they influence each other. The third part considers what economic conditions can lead to various corporate strategic decisions.
Finally, the fourth part describes four corporate level strategies used in the airline industry to overcome difficulties in a low growth environment. These corporate strategies are permanent exit, temporary capacity reduction, mergers and acquisitions, and joining global alliances.
Economic Environment and the Relationships Between Oil Price, GDP Growth Rate,
World Travel Demand, Foreign Exchange, and Interest Rate
This part of the analysis describes the global and regional economic environments and consists of five topics. The first topic investigates the relationship between the oil price and the GDP growth rate. The second topic shows the relationship between world travel
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demand and the oil price, and the third one is about the positive long-term relationship
between net profits and the oil price. The fourth topic is about the relationship of
currencies and problems with the US Dollar as a dominant currency, and the fifth part is about the positive relationship of interest rates and GDP growth rate.
To consider corporate strategies like permanent exit, temporary capacity reduction, mergers and acquisitions, and joining global alliances, the economic and financial
environment must be examined regarding relationships between growth rate and oil price, foreign exchange rate and interest rate. Data surrounding the crises of 2008, the event of the Great Recession, were used to investigate the relationships to determine dismal economic situations, which can lead to considerations to perform at least one of those four corporate strategies.
The basis of all data regarding oil prices is the Crude Oil Refiner Acquisition costs, which is the basis for tracking the oil price for the U.S. Energy Information
Administration and all other U.S. government agencies like the Federal Aviation Agency
(Figure 1).
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Figure 1: U.S. Refiners Acquisition Costs
Relationship between the oil price and the GDP growth rate. First, the oil price is
positive related to worldwide GDP growth, which means the higher the growth rates the
higher the oil price (figure 1 and figure 2). The crash of 2008 caused demand for energy to decrease because of lower demand by consumers through the economic contraction.
Consequently, this situation caused the oil price to decrease from $101.5 to $54.7 in
2009. Similarly, the global growth rate changed from positive 1.8 percent to negative 1.7
percent in 2009.
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The situation of 2008 and 2009 was not unique, and it can also be observed through the
comparison of the 3-year average growth rates of world growth in GDP, energy, and
specifically oil since 1970. Such movements can also be observed during the economic
contractions of 1975, 1983, 1991, 2001, and 2008 (Figure 3). During times of contracting
or low growth economic environments between 1981 and 1986, the oil price fell nominal
from $ 31.81 to $ 14.55 and between 1990 and 1994 from $ 22.22 to $ 15.59. Although
there seems to be an exception between 1975 and 1978, a time of high inflation, the oil
price rose nominal from 10.38 to 12.46; it fell slightly at the real rate from 30.90 to 30.81
US Dollar based on the dollar value of 2005. After the dot-com bubble in 2000 the oil
price fell from 28.26 to 22.95 in 2001.
To further demonstrate that the growth rate is measuring the demand, and how oil price and growth rate are related, a good example for investigation is the comparison of the
year of 2007, the year before the Great Recession, and the year of 2015.
In 2007 the oil price was at 60.6 U.S. Dollars and in 2008 at 101.5 dollars. The world
growth rate was at 4.3 percent and 1.8 percent in 2008. At first this data seems to be contradictory to prior findings above. Despite this, there is a delay in markets caused by expectations that demand is rising, although the demand had already contracted. In 2009
the price fell dramatically to 54.7 dollars per barrel, but in the same year, the GDP
growth rate for the world was already at negative 1.7 percent and for the United States at
an even lower negative GDP growth rate of 2.4 percent.
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In 2010 the world growth rate increased to 4.3 percent; consequently, the oil price rose to
74.6 dollars and to 96 dollars in 2011 with a 3 percent global growth rate, and reached a
high of 102.8 dollars in 2012. Once again, the growth rate fell to 2.4 percent in the same
year. After 2012, the oil price started to fall slowly to 100.8 dollars with a 2.5 growth rate
in 2013 and 2014. In 2014 the average oil price per barrel lowered to 97.8 dollars (Figure
2), while the global GDP growth rate moved between 2.4 to 2.5 percent. In 2015 though
the oil price fell to the spot average of 48.67 (U.S. Energy Information Administration),
the world growth rate was reduced to 2.4 percent for 2015 (Figure 8). Because of this fact, the world GDP growth rate no longer justified the oil price of around one hundred
U.S. Dollars. Thus, the plunge of the oil price to 48.67 US Dollars was predictable because it was a result of reduction in global growth and not just higher oil production in the United States. Therefore, supply alone is not responsible for low oil prices, and the fall of the oil price should have not been a surprise in 2015. This fall in oil prices was a
logical consequence of lower global demand and consequently lower worldwide GDP
growth rates.
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Figure 2: World Real Gross Domestic Income
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Figure 3: World Growth in GDP, Energy, and Oil
Gail Tverberg
Relationship between world travel demand and the oil price. The relationship between oil price and world travel demand in the airline industry is analogous to the relationship between oil price and the world GDP growth rate. The growth percentage of passengers of world travel demand shows passenger growth in 2007 at 8.8 percent, contractions at
1.5 percent in 2008 and 1.4 percent in 2009. This is despite a 46.1 percent decline in oil
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price during the same period. In 2010 the growth rate again was close to the levels of
2007 with 8.2 percent, despite an oil price of 74.6 $ per barrel in 2010. In 2011 the 5.1 %
passenger growth rate corresponds with the world growth rate of 3 percent. This creates the illusion that the oil price rose during the time of slowed down passenger demand between 2010 and 2011. However, the oil market is constantly delayed. Therefore, the oil price of 2011 is the result of a wide swing in customer demand as well as the world GDP growth rates from 2008 and 2009 to 2010. Therefore, the oil price of 2011 is reacting to the growth rate of the negative 1.7 percent in 2009 to the growth rate of positive 4.3 percent 2010 (figure 2) and the world passenger demand rate from negative 1.1 percent to positive 8.2 percent in 2010 (figure 3). This data proves that the world passenger demand rate reacts to changes of the world growth rate much faster than of the oil price. However, this delay in the oil price can be explained, that the oil price needs time to react to a new economic environment as it did during a time of low world GDP growth rates of 2.4 and
2.5 percent after 2012 and lower passenger demand rates of 4.6 percent in 2012, 5.3 percent in 2013 and 5.0 percent in 2014. Finally, during 2015 and 2016 the oil price fell to under 50 US Dollar. Thus, world customer demand rates in the airline industry are the result of global and regional GDP growth rates, and the oil price does not primarily effect world passenger demand (Figure 4).
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Figure 4: World Passenger Demand
Source IATA
Positive relationship between net profits and the oil price. When considering the supply and demand theory, higher demand also increases supply and raises prices (Dutt). In 2009 the low demand for air travel and other fuel dependent industries caused a global operating loss and net loss despite low energy costs. Consequently, there is a positive
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relationship between oil price and world air carrier profit. Even though 30% of all costs is
absorbed by energy costs (Clayton), the world carrier net profit was at 14.7 billion US
Dollars at a price of 60.6 US Dollar per barrel in 2007. However, a 26.1 billion US dollar
net loss occurred in 2008 at an oil price of 101.1 US Dollar. Following this year, a 4.6 billion US Dollar net loss occurred despite an oil price of 54.7 US dollar per barrel in
2009. Again, oil price adjustments were delayed because prices fall and rise as a reaction to market conditions. Thus, losses in the airline were much higher in 2008 than in 2009.
A similar situation in the opposite direction can be observed between 2010 and 2011. A
17.3-billion-dollar net profit was achieved by the global airline industry in 2010, but an
8.3-billion-dollar profit was achieved in 2011. This situation can be explained by the global upswing of the global growth rate from negative 1.7 percent in 2009 to a positive global growth rate of 4.3 percent in 2010 was so fast. The increase was so rapid, that the oil price could not adjust fast enough. Thus, the gas price rose to 96 US Dollars in 2011, while the growth fell from 4.3 percent to 3 percent, which caused the net profit compared to 2010 being halved in 2011.
Despite an oil price of around 100 US Dollars a 6.1-billion-dollar profit in 2012 and a
10.6 billion net profit in 2013 (Figure 5), a 16.4 billion profit in 2014 was achieved in the
airline industry (Fact-Sheet-IATA). Thus, over a long-term period higher GDP growth
rates generate higher global world carrier profits, but not low oil prices.
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Figure 5: World Air Carrier Profit/Loss
:
Relationship of currencies and problems with the US Dollar as a dominant currency.
Another subject is the foreign exchange rate and the strength of the US Dollar. The U.S.
Dollar is still the major currency; all airlines are mostly exposed to the rise and fall of the dollar (Oxley). For example, the savings in fuel price were diminished for non-U.S.
54 airlines by 10 to 15 percent in 2015, while US airlines enjoy the biggest profits
(Morningstar).
To determine if there is a relevant relationship between the world GDP growth rate and a strong US Dollar, the US Dollar Currency Index or USDXY is used as a proxy to compare global growth rates to the movements in the foreign currency exchange. The
USDXY is calculated by factoring in the exchange rates of six major currencies. If the growth rate of the United States is lower than the global rate, the USDXY factor is under
100. In 2015 the index was close to 100, because the global growth rate and U.S. growth rate were in sync.
In the same year, the USDXY was started with a base of 100 and all measures since then are relative to this base (Figure 6). This means that a value of 110 would suggest that the
U.S. dollar experienced a 10 percent increase in value over a certain period. Because of the strong appreciation of the US dollar in 2015 of about 22 points and the long-expected interest rate hikes in December 2015, USD-denominated costs like oil have risen by 10-
15 percent on average in local currency terms. Moreover, this index indicates that there is a relationship between the growth rate of GDP and the strength of the US Dollar. In
March 2008, the USDXY was at its lowest point near 72. On June 1st, 2016, the index is now at 94 (Figure 6).
There is a relationship between the value of a currency and its growth rates in the region where it is used. The value of a currency and the GDP growth rate are positively related.
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The strength of the US Dollar reflects the strength of the U.S. economy against other regional economies. However, even though the US Dollar is the dominant global currency, its strength is not the result of a high global GDP growth rate. The strong value of the US Dollar is negative for other regions because it is typically used as world currency to pay for commodities like oil and most financial services (Oxley). Therefore, a strong US Dollar raises energy prices and diminishes the global GDP growth rates of all other regions. Consequently, the health of the global economy is not determined by the strength of the US Dollar, but by the strength of GDP growth rates of all different regions.
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Figure 6: US Dollar Currency Index
Positive relationship of interest rates and GDP growth rates. Interest rates are positively
related to GDP growth rates of different regions. However, economies like Brazil with a
growth rate of negative 3.4 percent and Russia of negative 4 percent (Figure 8) have very
high interest rates set by their central banks to fight inflation. The Brazilian central bank
set their rate at 14.2 percent and the Russian central bank at 10.5 percent (Global-
rates.com) to fight their currencies’ devaluations against the US Dollar, the Euro, or the
Japanese Yen. To soften price shocks for their populations, Russia and Brazil support their own currencies to fight steep price increases of imported goods.
In standard economic theory, interest rates are positively related to the growth rate of
outputs (Lee). Higher potential growth affects interest rates because of two reasons. First,
higher interest rates increase the returns on investments, which attracts an increasing
57 demand for investments. Second, higher growth boosts future earnings, which influences households to consume more and save less. In 2014 the largest aerospace order ever was worth 38 billion US Dollar, between Boeing and various Chinese companies. This big deal is a good example of how moderate higher interest rates are positive for the economy. This deal includes a plan to establish a joint venture between Commercial
Aircraft Corporation of China Ltd. (COMAC) to open Boeing’s first facility in China.
The facility plans to serve as a completion and delivery center for future Boeing 737 airliners. In the deal, Chinese airlines bought 240 airplanes, including 197 737 airliners and 50 wide-body aircrafts. The other 60 737 airliners were bought by two leasing companies, Industrial and Commercial Bank Financial Leasing Co. and China
Development Bank Leasing Co. In the next 20 years the Chinese commercial airplane fleet is expected to grow from 2,570 planes in 2014 to 7,210 planes in 2024. One of
Boeing’s European rivals in China, Airbus Group SE, has already established two joint venture facilities with COMAC in China, the second of which is expected to deliver its first wide-body A 330 jet airliner in 2018 (Cameron).
Growth of an economy is positively supported by higher interest rates because firms grow faster. Growth of firms is achieved through a firm’s asset and revenue growth. Such firms need more resources to search for outside resources and invest money in human resource training and education, which will be resulted into increasing debt (Lee).
However, firms with high growth in earnings before interest and tax can keep high stock prices in anticipation of future high earnings and receiving more capital to cover the
58 additional expenses, which illustrates a negative relationship between debt and growth and the risk of bankruptcies decreases (Lee).
Contrary to the popular belief that low interest rates will make it easier for airlines to increase capacity by purchasing bigger newer airplanes, firms operating in moderately high interest rate regions are growing and modernizing their airplanes to the newest regulations (Lee).
High interest rates are positively related to demand for capacities through purchasing or leasing additional airplanes. The number of U.S. commercial aircraft is forecasted to grow from 6,676 airplanes in 2014 to 8,131 in 2035 during a time of expected higher interest rates and an average annual capacity growth rate of 0.9 percent. Since 2007, the
U.S. commercial airline fleet has contracted by 1,056 aircraft (FAA Aerospace Forecast
Fiscal Years 2015-2035) when the interest rate was at almost zero percent over that same period. Therefore, if there are higher interest rates justified by a moderately high growth rate globally, companies will expand faster. They also make more revenues and profits in the future because interest rates are a product of GDP growth rates.
Finally, energy prices, passenger demand in the airline industry, net profits, value of currencies and interest rates are all positive related to the global GDP growth rate. That means that everything is dependent on the GDP growth rate. Therefore, managements of global firms will engage more in exit and other corporate strategies in times of low global
59 growth than in times of high growth. This also means that the single most important factor to consider corporate strategic decisions is the growth rate.
Two Business Models of Low-Cost Carriers and Full Service Airlines
This part describes the characteristics of low cost carriers’ business models and the characteristics of full service carriers’ business models, the difference of consumer behaviors between the two business models, and the newest development of convergence between the two business models
Characteristics of low-cost carriers. First, low cost carriers have only one class of passengers, so there is no difference with the services all passengers receive. Seats are less comfortable than in full service airlines because they are narrower to achieve high seat density. Second, low cost carriers fly mostly one type of airplane. The most common types of airplanes used by low cost carriers are the Boing 737 airliner and the Airbus 320.
Both are designed for midrange destinations. Since low-cost airlines only have one kind of airplane, maintenance costs are reduced because the ordering of parts is simplified through having only one supplier. The training of pilots, maintenance personal and flight attendants is also simplified because they do not need to be trained on multiple types of airplanes.
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Third, low cost carriers are in the market predominantly to service point to point routes because that saves fuel and time by not having to stop at hubs. Also, the turnaround times are greatly reduced, so the round-trip flight to the destination airport would be quick as possible. And fourth, low cost carriers are using frequently second-tier airports, which have much lower fees than first-tier airports. An excellent example to demonstrate the advantage of flying to second-tier airports is the comparison of the three airports in the
Bay area in 2003. The fees for an airline to fly to and from San Francisco International
Airport were 18 US Dollars per passenger. At the same time the landing and rental fees to
fly to and from Oakland were only 3.72 US Dollars and to fly to and from San Jose, the
fees there were just slightly higher than in Oakland (Wong).
Characteristics of full service carriers. Most full-service carriers are operating globally, dominating the market of long range routes, and offering a lot more services than low cost carriers. For example, Singapore Airlines also offers full services on the ground including shuttles to hotels, reserving hotel rooms, rental cars, overnight stops over holidays in Singapore, etc. Moreover, this global firm serves long range destinations all over the world to 35 countries on six continents.
Singapore Airlines has 103 airplanes and seven different kinds of airplanes from Airbus,
A 350 and A 380 to Boing 777-200, 777-200 ER, 777-300 to 777-300 ER. Moreover, customers of Singapore Airlines are business travelers, who work on those airplanes and do business (Singapore Airlines). Consequently, business passengers are frequently
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flying full service airlines, whereas low cost carriers are serving a different cliental of
leisure customers, who are flying less frequently and demand less services.
Differences in consumer behavior between the two business models. In 2005 low cost carriers like Ryanair attracted a high number of younger people between the age of 18 and 25 (O’Connell)This counted for a quarter of all passengers of Ryanair, indicating that people with less financial resources are using primarily low cost carriers. Not surprisingly, 87% belonging to this passenger segment were travelling for non-business purposes, while most passengers of the age group ranging from 25 years to 58 years travel more for business reasons and prefer full service airlines (O’Connell).
Leisure passengers travel less often in their lifetime and have a higher tendency to travel
in pairs, families and groups, while business travelers tend to fly singularly.
Another group of leisure consumers are tourists. These consumers want to fly to their
vacation destination with as little cost as possible. Especially European travelers prefer to
fly with low cost carriers to their vacation destinations and want to save on their air
travels to spend their saved money on more expensive hotels, restaurants, and rental cars
(O’Connell).
However, business passengers prefer full service carriers because of service reliability
and quality, flight schedule connections, frequent flyer programs, comfort and safety.
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Thus, these travelers are more inclined to spend more money on their flights and to take
advantage of additional offered services, such as car rentals and booking hotel rooms.
Newest developments of convergence between the two business models. Low cost carriers
are increasingly more engaged in international and intercontinental flights and
conquering those markets through mergers and acquisitions. For example, the merger of
Southwest Airlines and AirTran gave Southwest access to airports in Mexico and the
Caribbean. Also, Europe’s Ryanair is expanding to markets in North Africa and the
Middle East. In addition, intercontinental flights are now also run by low cost carriers
like Norwegian Air Shuttle, which flies from Oakland, California to the Scandinavian
capitals Oslo and Stockholm. Nowadays ticket sales are mostly done on the internet by
carriers of both business models. Legacy carriers are adapting increasingly business
procedures from low cost carriers as a way to stay competitive.
Over the last ten years the North American market has seen a dramatic shift of market
shares from legacy airlines to low cost carriers. Only 55 percent of all revenues are
currently made by legacy airlines, and low cost carriers control 40 percent of the market share (Figure 7). Over the same time, the low-cost carrier Southwest Airlines became the biggest U.S. carrier by revenue passenger miles during the time frame of March 2015 to
March 2016 and holds an 18.2 percent market share. Consequently, the two business models adopt similar practices, which makes those business models less distinguishable, so airlines remain competitive. Airlines need to offer both, competitive prices and good
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services. Recently, even Ryanair, the Irish low cost carrier, has engaged in customer service improvements, by increasing the communication between customers and the airline, which provides the ability to detect customer complaints and the difficulty in
obtaining information regarding flight connections (Manduca).
Figure 7: Domestic Revenue Passenger Miles and Market Shares
Source: Bureau of Transport Statistics
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Conditions Leading to Corporate Strategic Decisions
The first section compares single airlines of different regions, and how local GDP growth rates influence their operating and financial performance by using their net incomes as a proxy. The second section shows how foreign exchange rates can cause problems with regions with negative GDP growth rates using the example of Venezuela. The third section will discuss the dangers of hedging, and the fourth will be about the use of forecasts to make the necessary decisions for choosing the adequate corporate strategic decisions.
Single Airlines of different regions. This following part is about ten airlines, which are low-cost carriers and full service carriers from four different regions operating in low and high growth rate regions (Figure 8).
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Figure 8: Economic Growth Rates in Various Regions of the World in 2015
European Union Region. Deutsche Lufthansa, one of the biggest airlines in Europe, is a privately owned full service carrier operating from Germany. Since 2006, with the exception of a losses of 112 million Euros in 2009 and 13 million Euros in 2011;
Deutsche Lufthansa had positive results of net profits of 990 million Euros in 2012, 313 million Euros in 2013 and 55 million Euros in 2014 (Morningstar). In 2015, Lufthana had a a record net profit of 1,698 million Euros mostly due to a sale of shares of JetBlue in
2015; however the first quarter of 2016 Lufthansa suffered a 53 million Euro loss despite an oil price of $30 (McGee). Therefore, the main reason for this loss is the low GDP
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growth rate in Europe, which was only 1.5 % for 2015. The low growth rate intensifies
the competition with the low cost carrier RyanAir for market share, which has become
the biggest European carrier in 2016. This situation has put a spotlight on structural problems within theDeutsche Lufthansa. This company has several subdivisions, which
are former full-service carriers of different countries, such as Swiss Air or Austrian
Airlines, but also low cost carriers, such as Eurowings. Therefore, Deutsche Lufthansa
now faces the same problem of having two business models under one company as U.S.
companies in the early two-thousands experienced.
The top European low cost carrier Ryanair had similar good results as Deutsche
Lufthansa. Ryanair reported a loss of 169 million Euros only in 2008. After having
profits between 305 and 867 million Euros between 2009 to 2014, their record profit of
1,531 billion Euros in 2015 (morningstar) is mostly based on an increase of 90.6 million passengers per year, on reduced empty seats, and increased market share especially in
Germany, where competitors reduced a series of scheduled flights. Temporary lower
costs in fuel price also has helped in reporting a higher profit for 2015.
Whereas, Air France/KLM has experienced losses of 590.33 million Euros, 1.03 billion
Euros, 1.71 billion Euros, and 221 million Euros throughout 2010 to 2014 . Finally, a
100 million Euro profit was reported in 2015 (marketwatch.com). Air France/KLM’s
profit was achieved through cuts in the workforce and lower fuel costs. However,
analysts pointed out that the weak operating margin of 3.1 percent was expected
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compared with Ryanairs’ 18 percent. AirFrance/KLM’s outlook of profit is seen as only
shortlived because the Euro is weak against the other major currencies, and the advantage
of global low energy prices is offset by a strong US Dollar. Furthermore, capacities of
other airlines are bigger, which pressure the revenues of AirFrance down. Thus, the expectation for future net profits is negative because of the recent terrorist attacks in Paris
and subsequent low fequency of flights to and from Paris (Powley).
These three airlines are operating from the Eurozone with a very low GDP growth rate of
1.5 percent for 2015 (Figure 8). However, these three examples show different results
despite the low growth environment in Europe. Markets with low growth rates cause
companies to engage into exit strategies. Deutsche Lufthansa has problems with its firm
structure and its fierce competition with Ryanair over price and marketshare. Therefore,
Deutsche Lufthansa is facing the possibility of using exit strategies of permanently
leaving markets, as its subdivision Austrian Airlines already did on the route from Vienna
to Rome in 2017 because of low profitability. Air France/KLM has problems with its
ownership structure because it is still partly owned by the French government with its
strong unions; thus, strong unions create problems with competition because of their
opposition to cutting wages and salaries to reduce costs. Therefore, there is a big chance
that Air France/KLM will not be able to turn to sustained profitability and face the
possibility of bankruptcy sometimes in the future. To the contrary, Ryanair as a low-cost
carrier is flourishing and is expanding despite an environment of low growth rates,
because it seems that costs are more important in times of low GDP growth rates, which
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gives low-cost carriers focused predominantly on costs an advantage against full service
carriers.
North America region. Currently, the U.S. GDP growth rate has reached the level of the
world GDP growth rate of 2.4 percent for 2015. In 2013 Delta had a record profit of
10.540 billion U.S. dollars because Delta was exempt from paying taxes due to the prior
bankruptcy filing of 2005 and dismal net losses of 8.922 billion dollars in 2008 and
1.237 billion dollars in 2009. Additionally, Delta enjoyed lower fuel prices than their
competitors through the purchase of a refinery in Pennsylvania of 2013 and the ability of
selling jetfuel to other airlines (Levine-Weinberg). Furthermore, the increase in revenue was not accompanied by additional higher costs, which lead to further solid profits of
4.526 and 4.726 billion dollars in the following years of 2014 and 2015.
Southwest Airlines is the prototype of a well-managed company because this firm has not experienced any net losses between 2006 and 2015. Its net profit was still 99 million U.S.
Dollar in 2009 despite the Great Recession, whereas every other U.S. airline experienced net losses. However, the net profits in 2014 of 1.136 billion Dollar and in 2015 of 2.181 billion Dollar were solid, but not as high as the profits of Delta Airlines and American
Airlines Group Inc. Southwest Airlines started as a typical low cost carrier serving only the U.S. local market till 2012. After the acquisition of AirTran Airways, the firm now expands slowly internationally into Mexico and the Carribbean.
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The American Airlines Group Inc is one of the legacy carriers, which experienced only
net losses between 2006 and 2013. These net losses were reported as low as 471 million
US Dollar in 2010 and as high as 2,071 million US Dollar in 2008. The company could
not sustain to operate with their yearly net losses of close to two billion US Dollars
between 2011 and 2013. Consequently, the company filed for bankruptcy protection in
2011. In 2013 American Airlines used the corporate strategy of merger and acquisition
and merged with US Airways to create “The American Airlines Group Inc.” In the same
year management changed and restructured the fare scales by adopting a simiar price
strategy of low cost carriers, closed needless facilities to maintain airplanes and saved
personal costs through new employee contracts. All these measures finally produced a net
profit of 2,882 billion Dollars in 2014 and a net profit of 7.610 billion in 2015.
As these three examples of Delta, Southwest, and American Airlines reveal, these airlines
profits are not only due to the advantage of low fuel costs (although the typical currency
for oil transactions is the U.S. Dollar and the US airlines can take full advantage of low
oil prices), but also due to their size and their geographical advantages with the
worldwide third highest GDP growth rate lately.
Asian-Pacific Markets. Japan’s GDP growth rate was just at 0.5 percent in 2015.
However, considering the economic circumstances, the performance of Japan Airlines Co
Ltd ADR is worth to be noticed lately. After the bankruptcy in 2010, this firm performed well throughout the period of 2012 to 2015. The net profits of Japan Airlines between
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2012 to 2015 were 191.574 billion Yen, 176.547 billion Yen, 170.386 and 153.925
billion Yen (morningstar). These profits, despite its own stagnanting local market, were
believed to related to the relative geographical proximity to neighboring countries with high growth rates like China of 6.8 percent and India of 7.5 percent in 2015 (Figure 8).
For being in the Asian Pacific region with the worldwide highest GDP growth rates, it is
not surprising that Singapore Airlines has not experienced one year of net loss between
2006 and 2015. Between 2006 and 2011 the net profits ranched between 1.148 and 2.202
billion Singapore Dollars, but this high level of net profits has not been reached ever
since. These are due to the liberalization of many popular routes to and from Singapore
by low cost airlines (O’Connall), and more importantly the reduction of the global growth
rates from 4.3 percent in 2010 to 2.4 percent in 2015 (FAA Aerospace Forecast Fiscal
Year 2015-2035), which explains the comparable meager net profit of 367 million
Singapore Dollars in 2015. While Singapore Airlines is a true global full service carrier
connecting 35 countries on six continents, it is still influenced by the changes in global
GDP growth rates (The Singapore Airlines Fleet).
Interestingly, China Southern Airlines Company had the only exception of 2008 with a
loss of 4.786 billion Yuan and consistently had net profits prior and after 2008. The
biggest profits were made with 5.795 billion Yuan in 2010 and with 6.090 billion Yuan in
2011 when the Chinese growth rate Chinese GDP growth rate was at 12 percent in 2010
and 10 percent in 2011 (Morningstar). In the environment of a 6.8 percent growth rate,
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China Southern Airlines Company achieved a 3.726 billion Yuan net profit in 2015.
China Southern Airlines Co Ltd ADR is now the third biggest airline in the world and
transported 110 million passengers during 2015 (Morningstar).
Currently, Asian airlines are earning solid net profits and expanding rapidly. Although
the Chinese GDP growth rate does not reach double digit anymore, the forecasts still see
the Asian Pacific region grow faster than the global growth rate for the next 20 years
(FAA Aerospace Forecast Fiscal Year 2015-2035). Moreover, the case of Japan Airlines
shows also that even airlines in a country with a low growth rate of 0.5 percent can flourish because of geographic proxemity to high GDP growth areas.
Region with contracting GDP growth rates. LATAM Airlines is the biggest airline in
South America. In 2012 the Chilean airline, LATAM, formerly LAN (Linea Aerea
Nacional) airlines and Brazilian airline TAM (Transportes Aéreos Meridionáis) merged
together to build a strong airline in order to withstand future economic problems. Since
2015 LATAM has its headquarters now solely in Santiago de Chile. This airline operates
also in Brazil, the biggest economy in South America, who has experiences political and
economical turmoils. As a result, Brazil has suffered from a negative 3.2 percent GDP
growth rate in 2015. In that year LATAM’s net loss was 281.11 million US Dollar, in
2014 the net loss was at 76.96 despite a very low oil price of 48.67 US Dollar per barrel
(Amigobulls .com).
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The data regarding net incomes of ten airlines above show that GDP growth rates have
influence on net incomes of airlines and lead to the following five findings. First, low
cost carriers, such as Southwest Airlines and Ryanair, which are the biggest airlines in the
United States and Europe, show that the low cost carrier business model is very successful. Even in times of economical difficulties these airlines were profitable when other full service airlines suffered heavy losses. Second, as a full service airline Deutsche
Lufthansa made a total transformation in ownership from government-owned to privately-owned. Over the last eight years, the carrier became more profitable through cutting employment costs and taking over small national carriers like Austrian Airlines and low cost carriers like German Wings. Third, the example of Delta Airlines shows that buying a refinery is also a way to modify the supply chain to control fuel costs and get less exposed to fluctuations in energy prices. This purchase also opened new revenues for the firm by selling to competitors kerosene. Fourth, for the forseeable future the Asian
Pacific market shows still solid growth despite a slower growth rate in China. Fifth, the case of the South American Airline LANTAM shows harshness to run a business in a dismal market like the South America.
Foreign exchange rate changes. Certainly, currency fluctuations influence customer demand on a regional level. For example, if the US dollar is strong against the Euro, more people from the U.S. travel to Europe and less Europeans come to the United
States. Obviously, airlines operating such flights will make more profit on Americans than on Europeans. However, if both countries are developed countries, such currency
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developments are only temporary, and those currency fluctuations are quite negligible.
Furthermore, the sensitivity of demand to change in exchange rates causes leisure travels being more effected by foreign currency fluctuations than business travels. Because low-
cost carriers are much more engaged in leisure travels they are exposed more to foreign
exchange fluctuations than legacy carriers; therefore, low-cost carriers must adjust faster to changes and consider the ultimate exit strategy to abandon markets permanently.
Nevertheless, if economies in Brazil and Venezuela with negative growth rates are facing stagflation and hyperinflation, global full service airlines will also experience significant problems. Foreign exchange rates in such countries are very volatile and negatively influence profits and costs of local operations like ticket sales, landing fees or air control fees paid in local currencies.
This following case of Venezuela serves as a good example to demonstrate how
deteriorating currencies hurt global companies. In 2013 Venezuela was facing a
deteriorating currency with the development of a black market for trading currencies
because of the government‘s mismanagement. In 2013 the U.S. Dollar was eleven times
higher valued than the official exchange rate. The Venezuelan Bolivar was traded at a
rate of 6.3 to the U.S. Dollar prior to January of 2014, but Venezuelan authorities
reviewed the "reasonableness" of airlines' profits to determine how much cash Venezuela
let repatriate global airlines to their home countries. Thus, the government set the official
rate to eleven Bolivars for one US Dollar. Therefore, the revenues of global airlines were
trapped. Per reports of the International Air Transport Association from October 2013 to
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January 2014, airlines' holdings in Venezuela increased 28 percent to 3.34 billion Dollar
from 2.6 billion US Dollar. Therefore, many airlines negotiated individually with the
Venezuelan authorities to minimize losses (Nicas).
Thus, Delta Airlines threatened the Venezuelan government to slash the frequency of
flights by 85 percent. This was due to the weakening of the exchange rate for
international airfares and recorded a 23-million-dollar charges in the first quarter based
on this devaluation of the Bolivar in the financial statements. In this situation, Delta
Airlines raised ticket prices to cover the loss created by the new lower foreign exchange
rate and used the corporate strategy of temporary reducing capacities like other global
airlines, such as American Airlines Group, Inc., reducing its traffic to Venezuela by 66
percent (Nicas).
Forecasts. Global airlines need to focus on the forecast of GDP growth rates in various
regions so that they will be able to decide whether to stay in or leave a certain market.
Currently, countries such as Brazil, Venezuela, Russia or South Africa are exposed to low commodity prices, and their GDP growth rates are contracting. Thus, airlines flying to these destinations need to raise the question if they should decide to leave the markets or not. For example, the Latin American market was the second fastest growing market behind the Asian Pacific market with GDP growth rates for the region of 2.7 percent until
2013. However, in 2014 the Latin American region was down to the overall GDP growth
rate of just 0.9 percent (Figure 9).
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The Federal Aviation Agency in its 2015 National Forecast Report indicates that the
Latin American market will resume a strong annual average growth rate of 3.4% between
2014 and 2035, creating a significantly higher growth rate than the average growth rate of
2.5 percent of the U.S. market (Figure 10).
Currently, there are two main questions regarding Latin America. The first question is:
Despite the bad economic circumstances, is it prudent to stay in the market? The second question is: Which corporate strategies should be used considering the strong forecast till
2035? If global airlines have the financial means to be able to stay in a market facing low revenues and losses for the time till the market is recovered, those companies will use the corporate strategy of temporarily adjusting capacities by reducing the frequency of flights or flying smaller airplanes to those destinations. Also, global airlines have the possibility of joining alliances with other airlines to save each other’s market share in order to keep the opportunity alive for profits in the future when the economy recovers. However, airlines without the financial means to sustain in this market will leave the South
American market permanently.
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Figure 9: World Real Gross Domestic Product Forecast
77
Figure 10: U.S. Real Gross Domestic Product Forecast
Source: IHS Global Insight
Furthermore, the two biggest risk factors in the airline industry are energy prices and
foreign exchange rates in the short run. To protect themselves from erratic and
unforeseen dramatic changes in those two rates, particularly legacy airlines and some
low-cost carriers like Southwest Airlines and Ryanair, are using the tool of hedging.
However, hedging is a risk on a fundamental level, and the most common known hedging in the airline industry is against fuel price. As Treanor, Rogers, Carter, and Simkins concluded in their study: “Exposure, Hedging, and Value: New Evidence from the U.S.
Airline Industry” that hedging against fuel is more important in times of rising oil prices than in times of falling oil prices. Furthermore, they also stated that investors are fond of
78 airlines, which are engaged in hedging against fuel prices, because investors see hedging as an insurance for protecting the value of their investments. Thus, over the next eight years of expected rising energy costs, hedging is adding more value to the firms and gives investors more incentives to invest into those firms especially over the next eight years of rising energy costs (Lee).
Figure 11: U.S. Refiners Acquisition Cost (Rate)
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Figure 12: U.S. Refiners Acquisition Cost Forecast 2015-2035
Per the FAA National Forecast Report of 2015, using the source of HIS Global Insight, the fuel price is rising optimistically to $120/barrel and pessimistically to $140/barrel by
2024 (Figure 12). The average growth rate in oil price will be between 10.2 and 10.5 percent per year between 2015 and 2024 (Figure 11). Therefore, hedging against fuel prices will become more important and prudent in the next eight years because of the risk of rising oil prices. However, hedging against foreign exchange rates has a history of being riskier because of being more unpredictable. Therefore, the possibility of hedging in the wrong direction is elevated as these following two cases of the South African
Airlines (Triana) and the case of Delta Airlines demonstrate (Nicas).
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In the late nineties, South African Airways expected that the value of the US Dollar
would rise because during that time the United States experienced solid growth generated
by new online businesses. But the good economic times of creating numerous dot-com
companies ended in a bubble in the United States, which burst in 2000. Thus, in 2003 the
US Dollar plunged 30 percent in value against the South African Rand. Therefore, the
decision to enter long-term plain vanilla currency forwards to hedge against the US
Dollar ended in a financial catastrophe caused by an unrealized hedging loss of 850
million US Dollar. To overcome a temporary insolvency, the South African government
had to provide guarantees to keep South African Airlines alive (Triano)
The other case of Delta Airlines and American Airlines against the government of
Venezuela shows that hedging against a currency with high inflation, as well as the
existence of a black-market value, is impossible because governments will try to
influence the market and freeze assets. In the case of Delta Airlines, American Airlines,
and other global airlines, the government in Caracas froze the revenues from selling
tickets to Venezuelan customers in 2013. Therefore, the firms could not repatriate their
revenues and were pressured to negotiate the exchange rate between the Bolivar on the
one side to other currencies including the US Dollar (Nicas).
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Corporate Strategic Decisions
Permanent exit strategic decision. Airlines engaged in point to point travels are more likely to face the possibility of a complete permanent exit because most of those airlines are low-cost carriers and are not backed by alliances and code sharing. Moreover, the customer behavior of leisure travelers indicates that these passengers do not need to travel and are strictly interested on price. Therefore, when macroeconomic conditions through various forecasts regarding gas price, interest rate, foreign exchange tend to get worse, entering a market would need more research including the possible exit strategies.
If the region expects a good growth rate over an extended time and enjoys stable political and economic conditions, the use of corporate strategic decisions will be more unlikely.
However, the improper assessments of markets and customers and the lack of proper forecast information can lead to market failures; therefore, firms will likely exit the market. Furthermore, high failure rates are more likely to occur under uncertain demands, financial instability and restricted availability of necessary resources (Dixit).
Corporate strategic decision of mergers and acquisitions. Airline industry’s mergers and acquisitions have two corporate strategic objectives. The first objective is to have a chance that not all assets and networks are lost if a firm declares bankruptcy. Thus, other
firms can take over assets and market shares and create heathier airlines instead of going
complete bankruptcy, selling assets at undervalued prices, and making networks
accessible to different competitors (Leo). After the dot-com bubble, some major
82 bankruptcies have led to acquisitions and mergers. The first such case in 2001, when
American Airlines took over Trans World Airlines. In the same year, Delta and
Northwest declared bankruptcy with the result of Delta acquiring Northwest in 2007.
The second objective is the creation of a stronger company, which can be done through acquiring other companies to better prepare for the challenging times and gaining access to new markets. In May of 2010, the merger of Continental Airlines and United Airlines was to create the world’s largest airline company and to dominate the inter-continental routes between the United States and Asia. The Southwest Airlines-AirTran deal had a different objective. Southwest Airlines acquired AirTran because AirTran had airport slots in 25 foreign airports in Mexico and the Caribbean. Thus, Southwest Airlines could obtain the first-time access to foreign markets, and it gave Southwest Airlines the opportunity to achieve the number one airline status by the revenues in the United States.
Corporate strategic decision of temporary reduction of capacities. Full service carriers can remain in markets during the troubled economic situations, such as in Venezuela in
2012 or during the aftermath of the earthquake in Japan with its Fukushima disaster in
2011. Moreover, resourceful airlines will make sure not to lose market shares during such times especially if the long-term forecasts promise high growth rates. For example,
American Airlines kept its flights to Venezuela even despite the held back of profits by the Venezuelan government during negotiations between airlines and government about new imposed foreign exchange rates. Moreover, American Airlines did not leave the
83 market because forecasts showed that the Latin American market would be the second fastest growing market in the world between 2016 and 2035 (FAA Aerospace Forecast
Fiscal Year 2015-2035).
Deutsche Lufthansa executed the same strategic decision during the Fukushima disaster in Japan. Because of a temporary shrinking demand of international passengers between
15 and 25 percent in the Japanese market, Deutsche Lufthansa, which was the biggest provider of connecting flights between Europe and Japan, used the corporate strategy of temporary reducing capacity to keep the market share intact. Nevertheless, this strategy enabled Deutsche Lufthansa to save personal costs and fuel costs by using smaller airplanes with smaller crews (Inagaki).
Corporate strategic decision of joining global alliances. Airlines engaging in code sharing and building alliances with other airlines can survive from the economic downturns through the cost reduction of sharing of sales offices, personal, capacities, maintenance and operational facilities. Another benefit is the sharing of exit barrier costs, that will save the individual airlines when they try to expand into the new markets.
Another benefit for joining global alliances is that profits can be higher because competition is reduced through the route sharing with partner airlines (Leon). Another advantage is that airlines’ experiences of global alliances can easily engage in other types of corporate strategies such as temporary adjusting capacities.
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Currently, three major alliances are in operation. The Star Alliance network has started in
1997 and now it includes 27 member airlines. The Sky Team network has founded in
2000 with a total of 20 member airlines now, and the Oneworld network has started in
1999 with currently 15 member airlines. Since September 2015, three other alliances were founded. They are the Vanilla Alliance based in the region of the Indian Ocean, the
U-Fly Alliance in eastern Asia and the first low-cost carrier alliance known as Value
Alliance.
These alliance networks have provided several benefits for passengers such as lower ticket prices, frequent departure times, increased number of destinations, shorter travel times due to the optimized transfers, and faster mileage rewards for frequent flyers.
However, in the long run two possibilities of disadvantages for travelers can arise. The first one is the possibility of higher prices when competition is reduced on certain routes.
The second involves with the frequency of flights between two destinations, which reduce the number of flights on certain routes. The reduction of flights will result into the passengers’ experiencing longer waiting times (Leo).
85
Chapter 4
FINDINGS AND IMPLICATIONS
Airlines are less willing to consider engaging into corporate strategic decisions if the economic environment is globally strong and is characterized through strong demands in the majority of world regions. The strong economic condition is measured by the GDP growth rate. If the global growth rate is strong, the global demand is high. Therefore, in the airline industry, higher global demand means more business activities, which will be resulted into an increasing business travels. To satisfy a higher demand, manufacturers and service companies will increase the number of their employees and wages.
Consequently, airlines will fly more to satisfy the higher demand of an increased number of leisure travelers since they are now able to afford to travel for their desired destinations.
High oil price should not be recognized as a negative signal, but as a positive sign of growing demand in a healthy economy. Therefore, firms typically earn high profits during times of high oil prices. Surprisingly, this is also true for the airlines industry, even though thirty percent of all costs are used to purchase fuel. As a matter of fact, more losses incurred through times of low oil prices during the Great recession in the years of
2008 and 2009 or in the years after the bust of the Dotcom bubble in 2000 when oil prices
86
were low. Therefore, energy prices are results of global demand, which means, if the
demand for energy weakens through lower industrial activities, the price for energy will
also fall. Consequently, the current low oil price is mainly a result of lower GDP growth
rates in Asia and contractions of economies based on energy and natural resources, for
instance, Brazil and Venezuela in South America or Russia.
Moderately high interest rates and a strong currency should be understood as a positive
signal because they are the result of higher growth rates. Investors always want to earn
high returns; therefore, higher interest rate regions with stronger growth rates will attract investors. Additionally, regions with stronger growth rates need better infrastructure such
as building new modern factories, etc. Thus, global airlines will experience an increase of
their activities such as increasing capacities through additional airplane purchases and
leases in those growing regions.
Individual airlines can be highly profitable and expand even in regions with low growth rates like Europe and Japan. For example, the Irish low cost carrier Ryanair can expand through financial discipline expressed by the lowest cost per passenger kilometer. Thus,
Ryanair can modernize and expand its fleet, and it is now the biggest airline company in
Europe.
Recently the differences between low cost carriers and full service carriers are becoming less clear. This is due to the low cost carriers’ need to offer their passengers more than just a good price. Low cost carriers are not only flying to secondary airports anymore, but
87
also to primary airports. Therefore, passengers of low cost carriers are not just tourists
anymore, but also frequent business travelers. These travelers are interested in expecting
additional services, which have been exclusively offered by full service airlines. On the
other side, legacy airlines like American Airlines are engaging in no frills cost structures
now, which have been primarily associated with low cost carriers.
Low cost carriers seem to be vulnerable to permanent exits on certain routes. The first
reason is their main passenger groups. They are primarily leisure travelers who are
reacting stronger to changes in the economic environment. The second reason for permanent exit is that low-cost carriers are not engaged in alliances and their lack of
financial resources and capacities to survive in the temporary poor economies. And the
third reason is that low cost carriers are flying more point to point routes that can be quite
vulnerable to the destructive competitive business environment.
Corporate strategies such as mergers and acquisitions can give faster access to new
markets, save costs, and give customers with the extended network access. Eighth,
companies are joining alliances to reduce their exposure to the destructive competitive
business environment. For example, the Star Alliance has 27 members. For example,
customers of Deutsche Lufthansa have also access to the network of Singapore Airlines,
another Star Alliance member. Therefore, travelers can take advantage by booking airline
tickets through dealing with just one office. Switching between airlines on
88 intercontinental travels can be done with one ticket. Furthermore, if there are delays and passengers are missing connections, alternative schedules can be booked rather easily.
The biggest weakness in the airline industry is the low profitability. It seems that the cost structure in the airline industry must be changed to become more profitable. The biggest cost in an airline industry is fuel. Therefore, the approach of Delta Airlines to purchase a refinery seems to be a great idea. Maybe Delta Airlines ‘solution can improve the cost structure of other airlines, too. Not only does the purchase of a refinery change the cost structure through reducing the cost for fuel price at Delta, but also it gives Delta new revenue sources by selling kerosene to competitors.
The Airline Industry is a true global industry by nature. The most important parameter for management to consider in developing the exit-related corporate strategies is the global and regional GDP growth rates. Global growth rates are influencing all other parameters as interest rates, foreign exchange rates, and the price of fuel. Consequently, despite the cost of fuel is 30% of all cost for a typical airline, managements in the airline industry should carefully study the detailed changes in global and regional GDP growth rates.
Therefore, the exit-related corporate strategies need to be considered if the growth rate is not sufficient or the regions suffering from economic stagflation or hyperinflation situations. Corporate strategic decisions can lead to complete permanent exits, a reduction in the flight schedule frequency or capacity, mergers and acquisitions, and the formation of alliances to avoid complete permanent exits. Additionally, it is quite
89
problematic to analyze economic environments such as oil price, customer demands,
foreign exchange rate and interest rates without considering the growth rates. Therefore,
global firms’ managers need to watch the changes in growth rates prior to any corporate
strategic decisions.
The Airline Industry is a true global industry by nature. The only important parameters for managements to consider in developing exit and corporate strategies in markets, are the global and regional GDP growth rates. Global growth rates are influencing all other parameters as interest rates, foreign exchange rates, and the price of fuel. Consequently,
despite the cost of fuel is 30% of all cost for a typical airline, managements in the airline
industry should primarily observe changes in global and regional GDP growth rates.
Therefore, exit and other corporate strategies need to be considered if the growth rate is not sufficient or regions suffer stagflation or hyperinflation caused by contractions in demand. Corporate strategic decisions can lead to a complete permanent absence in a market, a reduction in frequency or capacity, to mergers and acquisitions, whereas the weaker companies are getting absorbed by the stronger ones, and the buildup of alliances to avoid permanent exists.
Additionally, the need to analyze economic environments through parameters, like oil price, customer demands, foreign exchange rate and interest rates, without consideration of growth rates is problematic because growth is the main factor to determine the
economic health of a region. Therefore, an analysis of energy prices, interest rates or
90 foreign exchange rates without consideration of growth rates is fragmentary and will lead to flawed results. Therefore, managements of global firms need to watch changes in growth rates in forecasts first before making decisions about adequate strategies.
91
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