A MAGAZINE FOR EXECUTIVES 2008 Issue No. 1

T a k i n g y o u r a i r l i n e t o n e w h e i g h t s

A Conversation with Tim Hoeksema, chairman, president and chief the executive officer, pilot Midwest . pg. 36

Special Section I N SID E Airline Mergers Airlines are scrutinized for affects and Consolidation 26 on the environment

Etihad doubles its revenue from 44 2006 to 2007

Carriers can become true customer- 62 centric businesses

© 2009 Sabre Inc. All rights reserved. [email protected] Spurred by the open-skies agreement between the and the European Union, a new era of global competition is emerging. And just as every chess move reflects a strategic calculation, airlines are scanning a giant trans-Atlantic chessboard, trying to devise the right strategic moves.

By Chris Spidle | Ascend Contributor

C H E C K

M A T E

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igning of the open-skies treaty on April 30, What are the inclinations of the players? 4. Finding equilibrium — The airline industry will 2007, between the European Union and What strategies will be most effective? converge to a new balance point. The ultimate Sthe United States was an historic event How will the game board look in five years? extent of change will be determined by govern- from many perspectives. Previous experience in similar situations ment policy for mergers and rules for foreign The agreement grants any E.U. or U.S. suggests the industry could develop in four ownership of U.S. airlines. Unexpected geo- airline — for the first time — full traffic rights to phases: political or economic events could significantly fly between any point in the European Union and 1. Incremental change — Airlines will finally make influence the pace of change. any point in the United States. Among the numer- long-sought incremental changes based on Before speculating further on what actual ous changes this agreement brings, perhaps sound economic underpinnings, such as add- changes might occur during these prospective the biggest effects are being felt in the United ing service to large and previously restricted phases, it is important to understand the regula- Kingdom/United States arena — the largest and markets such as Heathrow. tory changes that have been introduced by the previously most restricted trans-Atlantic market. 2. Exuberant experimentation — There will be a open-skies treaty. Previously, only four carriers were allowed to period of innovation and experimentation as Game rules for the trans-Atlantic chess serve the United States from Heathrow airlines add previously prohibited new routes match now include expanded traffic rights and . With the agreement, additional carriers and/or flights. Precedents will be set as limits other new freedoms. There is now a single E.U. can operate flights from Heathrow to the United are tested. Expect a few trials — and probably market for air transportation as the European States. some errors, as well. Union replaces individual countries in bilateral Those who compare airline-network strat- 3. Survival of the fittest — Powerful basic eco- agreements with the United States. egy issues to a high-stakes game of chess with nomic factors will cull some of both the new The “community carrier” concept replaces multiple players can readily recognize the new and already-existing services. Networks and airline nationality. Now E.U. airlines may fly from rules as a game-changing event. The changes business models with sustainable economic any E.U. country to the United States — not just raise several pertinent questions: fundamentals will prevail. their home country. For example, What new business moves are now possible? can now fly from Belgium to the United States as

“Supportable Capacity” Paradigm

Supportable Capacity • Determined by •Local market size • Hub size MSP NW Height = • Distance to spoke ORD UA Local market size • Results in “neighborhoods” for hubs DSM Spoke • AUS = primarily DFW, IAH } ORD 8 flights • DSM = primarily ORD, MSP MSP 7 DFW 6 DSM IAH 2 Width = Hub size

DFW Line Width = AA Frequency

AUS Spoke IAH DFW 15 flights CO IAH 11 AUS ORD 3 MSP 2

Airline planners sometimes use the “supportable capacity” paradigm to describe the amount of capacity that a market can profitably sustain on a long-term basis. The construct illustrates that hubs have structural advantages for serving nearby points and that this creates natural neighborhoods for each hub. This effect is independent of political boundaries and is observable in borderless markets, such as the U.S. domestic market.

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has been a related flurry of activity regarding Heathrow slots. European Common Aviation Area Some details are unconfirmed, but media reports suggest that the going rate for Heathrow A multilateral aviation agreement among the 27 members slot pairs has rapidly increased to more than of the European Union and nine other European countries £30 million (US$60 million) for peak-hour tim- ings suitable for trans-Atlantic operations. U.S. Creates a common area for aviation by extending application carriers without close European partnerships of E.U. legislation to nearby areas have tended to pay the highest prices. Other Extends the E.U. internal air transport market U.S. carriers have pursued their European alli- Nine non-E.U. countries in the ECAA as of April 30, 2007: ance partners to try to obtain Heathrow slots. – Albania And SkyTeam partners even coordinated a – Bosnia and Herzegovina large reallocation of and KLM slots. – Croatia Coupled with additional slot purchases, this reallocation enabled SkyTeam, the alliance with – Iceland by far the lowest share of Heathrow slots, to – The former Yugoslav Republic of Macedonia add the most new U.S. flights at Heathrow — – Montenegro 11 new daily roundtrips. – Norway The fact that most U.S. carriers currently – Serbia entering Heathrow have retained some opera- – The UN Interim Administration Mission in Kosovo tions at suggests a consider- able amount of unmet demand for Heathrow slots and that there is continuing pressure to The European Common Aviation Area is a flexible framework that’s membership can shift more U.S. flights to Heathrow over the change over time. It includes all 27 E.U. countries plus additional adjacent countries. long term. Within the context of the E.U.-U.S. open-skies treaty, non-E.U. members of the ECAA Another pivotal step in incremental are defined to be the nine countries that were ECAA members when the treaty was change is increasing alliance network linkages signed last year. by adding hub-to-hub services. Even compara- tively smaller U.S. hubs such as Salt Lake City, Utah, are participating. And while some of the well as from the to the United Union reserved the right to begin rescinding free- new nonstop city pairs represent smaller local States. doms granted in Stage 1 if there is no progress in markets, all of the hub-to-hub routes nonethe- Many other rules on codesharing, pric- Stage 2 negotiations by the end of next year. And less serve as important pipelines for connecting ing, franchising and other areas have also been British Airways has already publicly stated that if traffic by fully linking the partners’ hub catch- relaxed. no real progress has been made by then, it will ment areas. On a global scale, the United States has ask the U.K. government to start the process of In addition to the growth at Heathrow already been fairly successful in achieving its rescinding Stage 1 freedoms in 2010. and in hub-to-hub flying, rapid growth is occur- stated policy goal of open-skies agreements That possibility, of course, could be ren- ring in boutique, all-business-class trans-Atlantic worldwide. And Europe, in general, has not been dered moot if business reality and success have flights. This growth actually started before the an exception. become so ingrained on both sides of the Atlantic regulatory environment changed, but it could For example, open-skies bilateral agree- by 2010 that neither side would really want to interact with and be influenced by the changes ments were already in effect between the United turn back the clock. that result from the open-skies agreement. States and 16 of the current E.U. countries. So An important, inconvenient detail is Two approaches have emerged for all- the new E.U.-U.S. open-skies agreement repre- that while the open-skies treaty offers greatly business-class trans-Atlantic flights: sents a bigger change between the United States increased traffic rights, it does not change the Legacy-affiliated — Wet-lease flights oper- and the 11 other E.U. countries that had either a requirement for airlines to obtain slots for flights. ated on behalf of European network carriers, more restrictive bilateral or no previous bilateral And it happens that some of the that Discount-boutique — Independent carriers agreement with the United States. represent the richest targets for airlines to take operating discount business-class flights in While the new agreement represents a advantage of the expanded traffic freedoms are the U.S.-London market. substantial change, it falls short of a few of the also the most slot restricted. The legacy-affiliated model focuses on E.U. negotiators’ key objectives for cabotage and However, carriers have been solving this full-fare business travelers, featuring narrow- foreign ownership restrictions for U.S. airlines. problem by essentially purchasing slots. Although body aircraft operated by Swiss/German airline Although the U.S. Department of E.U. law technically prohibits the buying and sell- PrivatAir and marketed by European network Transportation originally proposed terms that ing of slots, airlines operating there do trade slots carriers, linking major U.S. cities with top busi- permitted foreign control of U.S. airlines, these in a “gray market.” And airlines have tapped into ness centers in the European carriers’ home ownership provisions subsequently met strong this market heavily as they prepare to take full countries. Normal business-class fares are political resistance in the U.S. Congress. So U.S. advantage of the open-skies agreement’s new charged. This approach focuses every revenue negotiators offered different changes instead, freedoms. and cost advantage in markets with unusually and the modified agreement has gone forward high numbers of premium passengers. provisionally as “Stage 1” while negotiators con- First Moves: Incremental Change On the other hand, the discount-boutique tinue to work on what would eventually become Airlines have already announced schedule approach depends on access to a high-volume a final agreement in “Stage 2.” changes to take advantage of the additional local market with a large segment of customers To ease E.U. concerns that the United freedoms in the aviation agreement. Most of willing to pay more for comfort. Current opera- States now feels reduced incentive to negotiate these schedule changes involve U.S. carriers tors offer independently branded premium-class the remaining Stage 2 issues, the European adding new service to , so there seats in the U.S.-London market at a substantial

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E.U.-U.S. Open-Skies Agreement — Highlights

Element Change What It Means

Single E.U. market E.U. replaces individual countries in bilateral negotiations with U.S. Supercedes “Bermuda II” U.S.-U.K. bilateral

Additional airlines allowed into LHR-United States

“Community Carrier” Any E.U. airline can now fly from any E.U. country to the United Air France can now fly London-Los concept replaces airline States with full traffic rights Angeles nonstop nationality

Traffic Rights: open No restrictions on EU-US routes, frequency or capacity British Airways still may not carry Chicago- skies now applies to all Unrestricted fifth-freedom rights local traffic 27 E.U. countries Cabotage still prohibited Slot constraints still apply

Additional commercial Codeshare Unlimited between E.U., U.S., and third- and British Airways may changes country airlines codeshare on trans-Atlantic flights

Pricing All restrictions on E.U.-U.S. routes removed may start operations Franchising/branding Now explicitly permitted German Airlines could operate Seventh-freedom E.U. airlines gain full traffic rights to areas Belgrade-Chicago nonstop rights outside the European Union - European Common Aviation Area Virgin Nigeria may operate Lagos-Newark - Africa: 18 countries nonstop

Wet leasing E.U. airlines may wet lease to U.S. airlines for PrivetAir (Germany) could wet lease to U.S.-international operations American Airlines for New York-Stansted Cargo Unrestricted seventh-freedom rights for E.U. airlines

Competition Applications for antitrust immunity expedited by the United States

Ownership E.U. nationals owning U.S. airlines: Mergers between E.U. and U.S. airlines - 25 percent cap on voting equity remains in place are not possible at this time - 49.9 percent cap on total equity - 50 percent or more total equity possible subject to special U.S. approval British ownership of Virgin Nigeria does - E.U. nationals still may not control U.S. airlines not jeopardize its Lagos-Newark traffic Reciprocal rules for U.S. nationals owning E.U. airlines rights E.U. ownership of airlines in ECAA or certain African countries would not jeopardize their U.S. traffic rights An ECAA-owned E.U. airline would be treated as if it were E.U.-owned

Regulatory Cooperation Increased in many areas Joint committee established to interpret agreement

Other Provisions to increase reach of E.U. companies into U.S. market and vice-versa

The E.U.-U.S. open-skies agreement enables any E.U. or U.S. airline to link any city in the European Union with any city in the United States and offers additional freedoms covering many commercial areas besides traffic rights. It represents a major change for the large U.K.-U.S. market, which was previously regulated by the restrictive Bermuda II bilateral. discount from normal business-class fares, and Next Moves: Exuberant has historically been they fly larger or 767 aircraft. Experimentation extremely successful competing on the basis of Early experience suggests that all-busi- According to the classic pattern for market low costs. But there are fewer instances of new ness-class flights may be a specialized, fragile incursions, an innovative new entrant provides entrants competing for premium passengers. niche. Given the finite number of markets that a stimulus to the incumbent. The incumbent In the case of boutique airlines making meet either narrow set of criteria for the busi- responds. And the marketplace chooses a new incursions into the E.U.-U.S. market, incumbents’ ness models — perhaps only London, , equilibrium. Whether the new entrant is rebuffed plans for responses are well under way. Virgin German business centers, and Zürich — there or the incumbent cedes market share is often , a proven marketer, is prototyp- will be limits on how large these operations can determined by whether the new entrant seeks to ing an Airbus A319 for all-business-class trans- become. compete on a cost or revenue basis. Atlantic service. British Airways has announced

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If a carrier exuberantly over expands, some Countries Included In The E.U.-U.S. new flights will be unprofitable, and the venerable Open Skies Treaty Scottish financial theorist Adam Smith’s “invisible hand” of economics will take over: over time, as losses mount, the carrier will be forced to with- draw those flights. A few industry experts cite the concept of “supportable capacity” to describe what is

Iceland sustainable in the marketplace. This paradigm holds that the amount of capacity a carrier can profitably deploy from a hub to a spoke depends on three factors: Finland 1. The size of the local market in the hub, 2. The scale or size of the airline’s hub operation, Norway 3. The distance from the hub to the spoke. Sweden Estonia The three factors combine to determine Existing open-skies agreements Latvia the amount of sustainable capacity: Local traffic 16 countries Denmark Lithuania provides an essential foundation of higher-yield- N. Ireland Open-skies for first time ing traffic. However, connection customers are 11 countries Ireland needed to provide additional volume. And close United Additional ECAA countries Kingdom hub proximity lowers many costs. 9 countries Poland Netherlands Based on these factors, airlines can expect Germany Belgium to be economically penalized for certain longer Luxembourg Czech Republic Slovakia flights and benefit from higher-frequency short- haul flights. Austria Hungary France Romania Market fundamentals related to the sup- Slovenia Croatia Italy portable capacity concept suggest that hubs, Bosnia & Herzegovina Serbia & especially large hubs, tend to dominate their Kosovo Bulgaria nearby neighborhoods. Just as a very large tree Montenegro Portugal Macedonia casts a long shadow and takes up moisture, Spain Albania Greece nutrients and sunlight to deprive nearby seed- lings of the chance to establish themselves, the “hub-neighborhood” effect makes it harder for a Cyprus competitor to start services from a distant hub Malta to points that naturally fall within another hub’s “shadow” or catchment area — regardless of whether or not a route crosses country borders. The new E.U.-U.S. open-skies aviation services bilateral applies to 27 E.U. Due to the neighborhood effect, which is countries and represents the biggest change for the 11 countries that did frequently demonstrated in borderless markets not already have open-skies bilaterals with the United States — 16 countries such as the United States, natural or “home” already had open-skies agreements with the United States. Many terms of the territories emerge for each hub. In the case of agreement also apply to nine nearby non-E.U. countries, which are part of the Europe, the neighborhood effect might be slight- European Common Aviation Area. ly less pronounced since hubs are somewhat smaller than in the United States, and there is a plans for new all-premium flights from London ity than European airlines. And U.S. carriers stronger preference for nonstop flights. City Airport to the United States. And American also have fewer capacity limitations, such as But two other phenomena could enhance Airlines, a top player in the New York-London slots, at their home gateways. the effect of home territories: market, reinstated service to Stansted Airport, Past experience is that enthusiasm 1. The S-curve effect of market presence, which is the U.K. base of . for new freedoms and perceived competi- 2. Cultural preferences. Outside of the boutique arena, plans are tive pressures often drive frenzied carriers While the S-curve effect manifests itself now underway for British Airways’ new carrier to overindulge with their initial expansions. as “city” presence in the United States and “OpenSkies” to operate three-class Boeing 757s Then, over time, there is a retreat as suc- gives airlines an advantage in selling to custom- from New York to Brussels, Belgium, and/or Paris, cessful approaches are expanded and loss- ers originating in a hub or other city where the France. At a minimum, OpenSkies could be a use- making services are pruned. Winners and carrier has a large capacity share, in Europe there ful prototype for British Airways to fine-tune the losers are separated by the economic reali- is a “country” effect. A European airline’s home platform for serving nearby, non-home markets. ties of the marketplace. market usually includes the entire home country. Besides responding to the new all-busi- Cultural dynamics may reinforce this effect. ness-class services and the startup of OpenSkies, The Match Continues: Survival of The market fundamentals of supportable other airlines are likely to keep adding capacity the Fittest capacity and the neighborhood effect are not only on trans-Atlantic routes. The market continues Some industry-watchers speculate that very powerful but also they are independent of to experience double-digit revenue growth, and carriers will be tempted to invade one anoth- political boundaries. So even in a newly border- U.S. carriers continue to seek opportunities to er’s territories — for example, for Lufthansa less market, they still apply. Home territories will export their unprofitable domestic capacity. In to operate Heathrow-United States. But there still exist, making it more difficult for a smaller fact, it is possible that U.S. carriers have more are some natural limits that will influence the airline to invade a larger rival’s backyard or for a economic incentive to add trans-Atlantic capac- sustainability of such forays. hub to tap into a distant neighborhood.

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Airlines will continue to need some point mega-mergers between 2001 and year-end 2007: vice-versa, providing any new route “network of real strength on at least one end of a route American-TWA and US Airways-America West. strength” on both ends. for that route to be viable, whether that strength And recently, and Taking into consideration the large local derives from a network or a home territory. have announced merger plans, but further major market sizes, the highly developed networks that After the first moves and early expansions, U.S.-airline merger proposals are moving haltingly. low-cost carriers have built on each side of the the dynamics of supportable capacity, neighbor- Few if any of the possible U.S. airline combi- Atlantic, a newly deregulated marketplace and hood effect and home territories will determine nations involve overlapping trans-Atlantic routes, so the absence of any existing low-cost service, which changes survive. Changes that to their effect on E.U.-U.S. flights could simply be to there could be high growth potential for low-cost a carrier’s inherent strengths will have distinct stabilize supporting U.S. networks. carriers in the trans-Atlantic market. Perhaps the survival advantages throughout the evolutionary Unlike the United States, where consolida- dense U.K.-U.S. market will be the launch point period, while changes that amount to attempts to tion has meant direct merger with loss of one for such service. challenge intrinsic properties of airline economics carrier’s identity, the emerging model in Europe In the end, the differences between Stage will inevitably be eliminated. has the largest carriers such as Lufthansa and 1 and Stage 2 of the open-skies agreement may Air France using holding companies to manage prove slight. Although only Stage 2 permits full End Game: Finding Equilibrium acquired airlines such as Swiss or KLM as wholly control of U.S. airlines by E.U. nationals — and Overall, the trans-Atlantic market may at owned subsidiaries. These examples created a use- thus possible mergers between E.U. and U.S. first be churned to an extent — but it will eventu- ful template for possible subsequent cross-border carriers — Stage 1 does provide expedited review ally find a new equilibrium. mergers by preserving distinct cultural identities of requests for antitrust immunity, which is help- The two-phase nature of the open-skies after a merger while still consolidating fundamental ful for effective joint ventures. And Northwest agreement leads to the possibility that there will economics. and KLM have already demonstrated that joint be two separate balance points — the first repre- Just as several U.S. carriers might leap ventures can function as “virtual” mergers. senting the full extent of change possible under into merger action after a “triggering” event, the While it is impossible to know the future, the Stage 1 treaty, and the second for Stage 2. European industry is in some respects spring- we can project an airline industry with even larger The speed with which the industry converges loaded for consolidation. Given the high value of global carriers such as British Airways, Lufthansa to either of these points could be increased by Heathrow slots and the creativity of deals to date, and Air France-KLM each owning smaller regional economic shocks. Or the steady state for Stage 1 many possibilities could make economic sense if airlines plus perhaps a few large carriers adjacent could be bypassed completely should Stage 2 be owners are inclined to deal. to their neighborhoods. Additional antitrust-im- quickly agreed upon and implemented. And existing cross-ownership stakes might munized joint ventures are also likely. The future So the burning question clearly becomes: influence consolidation. For instance, if Lufthansa might also include fewer trans-Atlantic flights What will “equilibrium” look like? had proceeded to bid for , it might have been from smaller former flag carriers. Since regulatory influences have effec- interested in the 10 percent stake owned by British Many smaller markets will still have tively been reduced through the open-skies Airways. British Airways, in turn, might have been service, but some players might change, as agreement, economic factors can be expected to interested in Lufthansa’s 29.9 percent stake in bmi. in OpenSkies replacing in New York- govern more strongly. The neighborhood effect SAS could have entered the picture, too, due to Brussels. Competition among global carriers will will give larger hubs substantial advantages over either its stake in bmi or in . remain fierce, as evidenced by the rush to add smaller hubs. And over time, the gap between Lufthansa is strategically positioned as a service to Heathrow. And low-cost carriers could large and small airlines will grow. potential kingmaker through its significant owner- provide relentless price competition. In Europe, history has shown that although ship stakes in leading carriers at the top two trans- There is some risk that negotiations over economically troubled airlines may shrink, they do Atlantic gateways — bmi at Heathrow Airport and Stage 2 will deadlock and that this would call not usually vanish completely. Additionally, while jetBlue at New York’s John F. Kennedy International Stage 1 into question. But by then, it might be some smaller hubs may currently be overbuilt, Airport. hard to turn back. they aren’t likely to disappear altogether. In both Because of the relatively higher cost struc- There are extremely high stakes on each of Europe’s first major airline collapses, the end tures of European versus U.S. airlines, it’s hard to side of the Atlantic. U.S. carriers will want to pre- game was intercontinental growth opportunities imagine traditional mergers such as Air France-Delta serve access to Heathrow. And E.U. airlines will for nearby rivals and regional opportunities for a Air Lines combining to form a single company. It’s want influence over key sources of feed traffic in smaller successor to the failed carrier. easier to imagine U.S. carriers as subsidiaries of the United States. These factors — plus a gener- The largest airlines can be expected to European airlines’ holding companies. European ally higher level of business integration between defend their neighborhoods, as slots permit. carriers already own stakes in their key partners E.U. and U.S. airlines — should create strong Situations such as Air France’s entry to London- around the world. economic incentives on both sides to somehow Los Angeles and a possible British Airways/ A hypothetical British Airways-American resolve issues on a more permanent basis. OpenSkies venture into Paris-New York might Airlines combination would be formidable, with The multilateral game of chess will contin- represent a “checkmate.” hubs in New York and at Heathrow — the most ue. And although its participants may be grouped British Airways is even now matching U.S. important gateways on each side of the Atlantic. into fewer and larger teams, their business strate- carriers’ moves of Gatwick flights to Heathrow With strong city presence in both New York and gies will still be highly sophisticated, and competi- to avoid what could otherwise quickly become a London, this combination would be well-positioned tion will remain strong. a competitive disadvantage. to compete vigorously with the U.K.-U.S. boutique Whether and how much consolidation airlines. occurs on either side of the Atlantic could be One of the most dramatic possibilities in strongly influenced by government regulation, the trans-Atlantic arena is the prospective entrance antitrust policies, the intensity of economic stress of a low-cost carrier. Several are well-positioned on airlines, and the presence or absence of eco- to do so: Ryanair from London’s Stansted Airport; nomic or geopolitical shocks. easyJet from London’s Gatwick Airport; or jet- Chris Spidle is delivery director of Highly regarded industry analysts have Blue from John F. Kennedy . research, analysis and modeling for Sabre long predicted further consolidation in the U.S. U.S. low-cost carriers could potentially serve as Airline Solutions®. He can be contacted airline industry. However there were only two feed partners to a European low-cost carrier or at [email protected].

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