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Aviation Strategy. Observers of the European aviation scene might be experiencing. Will Europe really rationalise? CONTENTS PUBLISHER

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Issue No: 46 July/August 2001 Will Europe really rationalise? Observers of the European aviation scene might be experiencing a sense of déjà vu - a deepening recession, flag-carriers in trouble, appeals
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Issue No: 46 July/August 2001 Will Europe really rationalise? Observers of the European aviation scene might be experiencing a sense of déjà vu - a deepening recession, flag-carriers in trouble, appeals for state aid, national interest arguments, EC enquiries. Yet there are important differences between the situation today and the crisis of the early 90s. Back then, flummoxed by a combination of liberalisation and a severe market downturn, a large majority of the European scheduled airline industry supported, explicitly or implicitly, the need for state aid for failing flag-carriers. Only BA and KLM strongly opposed the concept. However, there were two different groups of state aid supplicants: The continental Euro-majors - Air France, Iberia, Alitalia - which needed large injections of state funds, they claimed, to implement the turn-around plans that would enable them to compete with the threat from the US mega-carriers. (Lufthansa, itself in dire financial straits in the early 90s, kept a low profile on the issue and was helped out by its government with its pension fund problem.) The Euro-minors from Europe's small and/or peripheral countries - Sabena, Olympic, TAP, Aer Lingus - whose political owners found it inconceivable that their states could live without a flag-carrier with intercontinental reach. But today Lufthansa and Air France have overtaken BA and KLM in terms of financial results; Iberia is majority privatised and under strong management; Alitalia is still a problem but is part-privatised and about to join SkyTeam. So, in contrast to the early 90s, there is no lobby at the moment from the airline establishment for new state aid. Indeed, BA's recent letter to Competition Commissioner Monti, in which it strongly opposed any assistance for Sabena and argued that any such intervention would postpone the overdue rationalisation of the industry, probably reflects the view of all the Euromajors. What in practice does European rationalisation imply? At the most basic level, it means that the Euro-minors will have to find themselves a genuine niche or disappear. The catastrophe of the SAir Qualiflyer strategy has finally proved that it impossible to create an artificial market base in order to compete with the Euromajors. What was not addressed in the last round of state aid and associated turn-around plans was the question of the Euro-minors' long-haul operations. Generally these are very loss-making for a combination of reasons - low yields associated with VFR or leisure traffic, seasonality, often expensive new A340s, [cont. page 2] We have combined the July and August issues to cover the summer holiday period. We will probably make this combination permanent, but current subscribers will have their subscriptions extended by a month. Analysis Recession, rationalisation and subsidy 1-2 Ryanair, just too good a negotiator 3 Boeing refines the Sonic Cruiser message 4 The lessors role in a recession 5 Air cargo: future trends 6-9 US stock prices 9 Briefing CONTENTS Virgin s airlines : what s real, what s hype?10-14 Management The cross-functional challenge Value trends 19 PUBLISHER Aviation Economics James House, LG, 22/24 Corsham Street London N1 6DR Tel: +44 (0) Fax: +44 (0) July/August 2000 Analysis Aviation Strategy is published 12 times a year by Aviation Economics on the first of each month Editor: Keith McMullan Associate Editor: Heini Nuutinen Subscription enquiries: Keith McMullan Tel: +44 (0) Copyright: Aviation Economics All rights reserved Aviation Economics Registered No: (England) Registered Office: James House, LG 22/24 Corsham St London N1 6DR VAT No: ISSN The opinions expressed in this publication do not necessarily reflect the opinions of the editors, publisher or contributors. Every effort is made to ensure that the information contained in this publication is accurate, but no legal reponsibility is accepted for any errors or omissions. The contents of this publication, either in whole or in part, may not be copied, stored or reproduced in any format, printed or electronic, without the written consent of the publisher. no economies of scale, expensive and excessive crews, low brand awareness abroad, little distribution power, etc.. They are just not a commercial proposition. Yet national political pressure against rationalisation of these routes will be intense. Olympic, if it pulls off the long-hauls as part of its restructuring and sale to an investor, will be accused of abandoning Onassis's dream and betraying the Greek Diaspora in New York and Melbourne; Sabena's unions will bewail the fact that it will be reduced to the status of feeding an intercontinental partner at Brussels (American Airlines?); Portuguese politicians will emphasise the need to maintain links to the former colonies; the Irish will raise the spectre of being taken over by the British. The table above summarises the scale of the long-haul rationalisation challenge. About 31% of the AEA traffic on the North Atlantic is carried by airlines other than the big four. Some of these carriers, in order to survive, will have to downsize into intra- Europe specialists feeding intercontinental passengers to the Majors at their hubs. Others like SAS and Finnair may have found a niche in point-to-point operations which can generate yield premiums; Iberia should have a competitive advantage in the South Atlantic market. The situation of Swissair and Alitalia is more complicated. Swissair has to concentrate on rebuilding its brand, which is a lot more difficult than losing it, and coolly assess whether there is sufficient Swissbased, high yield traffic for it to continue as an independent operator. Alitalia appears to be thinking previously unthinkable thoughts about its long-haul operation (see Could AZ live as AF's junior partner? , May 2001). It will create a joint STRUCTURE OF THE EUROPEAN LONG-HAULS N. Atlantic Other long-hauls Pax (m) Share Pax (m) Share BA % Air France % Lufthansa % BA % Air France % Lufthansa % KLM % KLM % Euro-majors % Euro-majors % Swissair % Iberia % Alitalia % Swissair % Aer Lingus 905 4% Alitalia % Sabena 902 4% TAP 583 2% Iberia 873 4% SAS 444 2% SAS 683 3% Austrian 339 1% Austrian 309 1% Finnair 257 1% Olympic 260 1% Sabena 225 1% Finnair 208 1% Olympic 138 1% TAP 184 1% Others % Others % Total % Total % Source: AEA Note: Data refers to 1999 venture company with Air France, which will coordinate and manage all flights behind and beyond France and Italy. In other words, Alitalia must be considering streamlining its own disparate and loss-making long-hauls and feeding its passengers to Air France's mostly profitable intercontinental flights at the CDG hub. A stern EC? To facilitate this rationalisation the EC will have to stake a firm line on further state aid, either direct or circuitous. EC officials are looking stern but the politics are convoluted. It is unclear if one time, last time is legally enforceable. Does it mean that any second round of state aid will be automatically refused, regardless of the merits of the case and despite the precedents set by Air France and Iberia in the mid 90s? The rational investor criterion sounds fine in principle but is nebulous in practice. Equating a rational investment decision with one made by a private sector company - as Sabena will attempt to argue - is dubious. Who now regards the investment decisions made by SAir's former management as being rational? Ryanair, just too good a negotiator At the core of Ryanair's strategy is its airport policy. Ryanair has discovered two vital bits of information: first, that despite received wisdom there is excess airport capacity in Europe and,second, that secondary airports are willing to pay airlines to come to them. An important insight into Ryanair therefore emerges from the agreement reached with Brussels South Charleroi Airport (BSCA) whereby Ryanair will establish its first continental European hub there and will commit to the airport for at least 15 years. The deal has caused another aviation controversy in Belgium, this time over the extent of the incentives Ryanair managed to achieve. According to a leaked master agreement between the two parties, Ryanair will pay extremely low landing and handling charges to BSCA, that are strictly based on the number of departing passengers. In addition, BSCA will pay Ryanair's expenses for local crew hiring and training, and crew hotel and subsistence costs during the establishment and development of the airline's base at BSCA. Moreover, BSCA will pay Ryanair to promote the airline's new routes out of Charleroi. Landing and handling charges will each start at 1 per departing passenger in 2001, creep up to 1.13 in 2006 and culminate at 1.30 in Hotel and subsistence costs during the start-up phase totalling 250,000 will be paid to Ryanair in monthly instalments of around 20,000. The hiring and training of pilots and cabin crew for the new routes to be operated from Charleroi is costed at 768,000, to be paid to Ryanair in four quarterly instalments. For each new route opened from BSCA, Ryanair will receive a one-time incentive of 160,000, up to three routes for each aircraft based at Charleroi (ie, 12 payments). The money will be paid in two instalments over two seasons. Marketing financial support given by BSCA to promote Ryanair services from Charleroi will be channelled through a joint venture. BSCA will pay Analysis Ryanair up to 4 per departing passenger. This payment is meant to reflect a 50/50 sharing with Ryanair of the costs of marketing the new services. In the table below we have conservatively assumed 2 per passenger, in effect negating the landing and handling charges. BSCA also commits to providing Ryanair with office space free of charge and hangar space at minimal cost. There is, however, a long-term commitment for Ryanair, and it will be forced to repay the incentives if it pulls out or downsizes within the 15-year period. On the other hand, BSCA seems to be willing to compensate Ryanair if other, unspecified things go wrong with the Charleroi operation: The Walloon Region and/or BSCA undertake to indemnify Ryanair against any losses (including loss of profits) incurred as a result of such reasonable expectations not being met, unless the exercise by the Walloon Region and/or BSCA of their regulatory powers shall have been dictated by EU, ICAO or other international law requirements . Finally, as if just to prove what a tough negotiator it is, Ryanair has had a clause inserted to the effect that it can claim for 4,000 of office equipment expenditure. That might be regarded as pushing things too far. ELEMENTS OF THE BSCA AGREEMENT (Euros) Ryanair's payments to BSCA Assumptions Landing fees 1,000,000 Annual pax 1,000,000 Handling fees 1,000,000 New routes 12 Total 2,000,000 BSCA's payments to Ryanair Unit fees or costs Marketing fees 2,000,000 Landing fees/pax 1.00 Hotel costs 250,000 Handling fees/pax 1.00 New route payment 1,920,000 Marketing contribution/pax 2.00 Recruitment payment 768,000 Hotel costs/year 250,000 Office costs 250,000 Payment/new route 160,000 Hangar costs 250,000 Recruitment/training (one off) 768,000 Total 5,438,000 Office costs( est) 250,000 Hangar (est) 250,000 Net benefit 3,438,000 Analysis Boeing refines its Sonic Cruiser message Boeing was quite convincing in presenting its new concept aircraft, the Sonic Cruiser, at the Paris Air Show. A roll-call of big airlines have made nice noises about the plane and Boeing is much encouraged by this display of enthusiasm. There is no doubt Boeing is trying to launch something, even if it turns out to be not quite what it seems. The airlines are bound to be interested. The Sonic Cruiser, flying at 40,000 feet and 95% the speed of sound offers interesting possibilities. John Roundhill, vice-president for marketing of the new aircraft, claims it will be 15% to 20% faster than today's jets. Not only would it cut one hour off an Atlantic crossing, and up to two and a half hours off a long transpacific route, such as Los Angeles-Singapore, its speed could also be used to squeeze more round-trip journeys into a day, thereby increasing productivity. Its 9,000 nm range will enable more non-stop flights and allow departure times to be set later to tap demand. The earliest entry into service would be 2006, but it is more likely to be A launch decision is expected before the end of next year, introducing, according to Roundhill, the potential to radically change the way the world flies . The biggest hurdle to overcome in making that possible will be convincing airlines of Boeing's claim that this aircraft can fly economically at just under the speed of sound. As the laws of aerodynamics would normally make the extra speed disproportionately expensive, Boeing must have some technical advance up its sleeve. After all, it claims that fuel consumption will be similar to today's aircraft . Boeing forecasts that the air travel market is fragmenting over the Pacific the way it has seen it doing across the Atlantic. As bilateral air traffic agreements become more liberal, Boeing thinks passengers will increasingly demand to fly direct rather than through a hub airport to reach their destination. As evidence of fragmentation, it points out that in 1987 there was only one service from Chicago to Europe, a TWA 747, compared with and 777 services today. Airbus's traffic analysts respond this is an exaggeration of the fragmentation trend since it considers only USbased airlines. Had the European carriers been factored into the equation, that would have shown lots of fragmentation even in Still, Roundhill predicts rapid growth of services from east and west coast American directly to the likes of Seoul, Beijing, and Guangzhou, in addition to traditional hubs such as Tokyo and Hong Kong. He notes that the share of 747 flights to and from Tokyo's Narita international airport has fallen from around 90% to well under half, reflecting the fact that proportionately fewer passengers are using the airport as an Asian hub, because of the growth of point-to-point services. When he presents the sonic cruiser, Roundhill talks about the first configuration being anywhere between 100 and 300 seats, leaving himself plenty of leeway, but his charts place it smack in the 200 to 250 seats bracket. He also remarks that the company is exploring other offerings in the same part of the market. The same niche? This is about the only point at which the Boeing view and that of Airbus link up. The way Noel Forgeard, chief executive of Airbus SAS (Société aux Actions Simplifiée, legally formed in July month out of the old Airbus Industrie GIE consortium), sees it, both groups are looking at the same market niche. This is the 200 to 250- seater slot occupied at the moment by two ageing models, the A300 and the 767. Airbus has been talking to airlines about how to serve this niche. As Forgeard sees it, the airlines are weighing up size, range, speed, economy and noise when it comes to defining what they would like. He thinks Boeing has refined that all down to one factor, speed, which Airbus calculates, predictably, will make the Sonic Cruiser 35% thirstier than aircraft flying at Mach 85. He says the feedback Airbus gets is that the airlines are most interested in getting a new plane with operating costs 10-15% lower than present offerings. We will have ideas for this segment, he says, but suggests they might be four years away. So the next Boeing/Airbus battle might be speed against economy in the mid-size category. The role of lessors in a recession Analysis Airbus was able to announce orders for 150- plus aircraft at the Paris Air Show compared to three 777s from Boeing. But most of Airbus's orders came from ILFC, which highlights the importance of the operating lessors as the recession deepens. Unfortunately, there seems to be a stream of bad news about the state of the main economies and the airline sector. In the US both load factors and yields continue to deteriorate badly while in Europe scheduled traffic growth turned slightly negative in April. Asia, having struggled out of its regional crisis, now looks as if it will implode again. And pilots unions at a range of carriers have chosen this time to become militant. The industry's leading guru on jet supply and demand, Ed Greenslet of ESG, has just produced his annual outlook. It is reassuringly depressing. ESG now sees the global surplus rising from 600 jet units in 2000 to just under 1,500 in This overcapacity is the equivalent of almost 9% of supply, which is not too far away from the surplus figure calculated in the depths of the early 90s recession - 10%. In short there are too many aircraft scheduled for delivery over the next few years, about 1,200-1,400 a year during or 800-1,000 if one excludes the regional jets. But among these deliveries are about 200 jets a year designated for the operating leasing companies, and which one might think are likely candidates for deferral. This happened on a substantial scale in the last recession mainly because LESSORS ORDER POSITIONS Total Sch. delivery Orders AWAS Boullioun CIT Debis GATX Gecas ILFC Pembroke SALE TOTAL Source: ACAS LESSOR DELIVERIES BY TYPE Sch. delivery Type Orders Boeing A A A A A A A Airbus Bombardier CRJ Embraer Dornier 728JET TOTAL Source: ACAS Note: 2001= second half of year GPA, over-exposed and under-financed, collapsed. The two mega-lessors, ILFC and Gecas, are today totally financially sound, indeed have much better credit ratings than the manufacturers and their airline customers. The smaller lessors might be feeling less comfortable though - hence the recent M&A activity in this sector. It would appear that the mega-lessors have the strength to pass off the pain of this recession on to the manufacturers. ILFC and Gecas together account for 22% of Boeing's backlog and 38% of Airbus's backlog, which puts them in a very strong negotiating position, especially with Airbus. They are also supposed to have made very good deals with the manufacturers on progress payments, more like 5% than 25% for the interim payments up to delivery. If there is a substantial level of deferral activity on the part of the lessors, this should mitigate the impact of the recession on the airline industry. They will in effect be acting as a shock-absorber, preventing supply and demand diverging as much as they otherwise would have done. Analysis The future for air cargo * The Global Air Cargo Industry, a report authored by Dr Borislav Bjelicic of DVB VerkehrsBank Industrial Research verkehrsbank.de The establishment of separate cargo subsidiaries, greater cooperation with alliances, vertical integration with forwarders and a relocation of cargo operations to secondary airports - these are the key trends in the air cargo business identified by DVB*. Closer links will develop between the members of air cargo alliances as the trend towards the formation of independent air cargo companies, achieved through a hiveoff of cargo operations, gathers momentum. Lufthansa has created Lufthansa Cargo and has announced plans to acquire a 49% share stake in SAS Cargo. Iberia has also stated its intention to form an independent air cargo company. JAL plans to establish a separate company but only for the purpose of marketing freight capacity. Northwest has formed NWA Cargo which will be responsible for freighter operations and the marketing of the belly holds of NWA's passenger aircraft. Singapore Airlines Cargo gained its own AOC earlier this year. It is interesting to calculate the scale of the role alliances could play in air cargo transportation if all member airlines co-operated closely. Close on 57 % of total FTKT is already produced by member airlines of the five alliances (including Qualiflyer) and airlines linked to these alliances. Star enjoys the most significant potential, oneworld ranks second followed by SkyTeam and Wings. An increa
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