The airline industry is facing its greatest challenges ever. Hub networks are getting critically congested at its busiest parts, space for growth is limited, operational dysfunctions are more frequent and quality of service is at its lowest level ever. Both legacy and low fare airlines are in search of new identities, merging the elements of low-cost and full-service business models.
Despite growing operational difficulties, in 2015 European airlines achieved an average operating margin that was three times higher than at any time in the past decade and the airline industry as a whole achieved above the normal return on invested capital. The fact that profits generated in 2015 and 2016 were mainly the result of a cyclical fall in the price of jet fuel raises many questions about the industry’s prospects. Still, major airlines continue to invest massively in fleet expansion, risking overcapacity, more disruptive air travel, and increased pressure to reduce prices.
Preoccupied with financial metrics disconnected from changes in operational reality, airlines are drifting deeper into failure. Instead of improving from within, they are constantly looking for the next in the line of temporary financial reliefs. They continue to measure progress by fragmented KPIs which are poor proxies for reality that say nothing about quality, nor about its relationship with cost in particular when exposed to changes in planned operations. Airlines actually do so poorly on the cost and quality side, that when in need to cut costs they do it by the pay cuts and layoffs of employees. As for the passengers, they keep deluding them with lower fares while worsening their travel experience.
How well will airlines be prepared to face the next cycle of higher fuel prices, and how hard it will be for companies exposed to a high level of operational risk and passenger dissatisfaction to keep their business afloat? What is it that drives airlines in the direction that doesn’t look sustainable in the long run, and what are the remedies?
In search of answers, I came across Alex Dichter’s articles that shine more light on these controversial issues. Alex is a Senior Partner in McKinsey's London office and leads the company’s global Airline, Travel and Aviation practice. He is a former pilot, instructor, and a very frequent traveller - a rare combination of experiences that include financial, strategic, operational, and organisational side of the airline business. He kindly accepted my invitation for an interview to share his views, and explain not so obvious issues that are shaping the future of airline business.
(JR-Jasenka Rapajic, AD-Alex Dichter)
JR: Corporate performance reports are the compilation of disjointed financial and operational inputs translated into KPIs and as such don’t seem to be reliable enough for making good system decisions. On the financial side, ROIC (Return On Invested Capital) is used as the industry benchmark for airline financial performance. Is this the right measure of the capital, and how much does it divert the attention from deteriorating business fundamentals like sustainability of the existing business models, stability of operational performance, and service quality?
AD: Whether or not ROIC is distracting, very few people lower down in an airline will think about ROIC. For the most part, they are focused on operational performance metrics and hopefully on driver-based metrics. If you run an airline, you want your head of airports to focus on the number of gate agents per departure, or the percent of self-check-ins. These are the things they can locally control and include cost and quality. But, at senior management level, there are some issues with ROIC that have a potential to distort decision making. This is one of the essential traps in the industry. The first among them is the way in which airlines account for costs. Accounting standards allow them to account for maintenance expenses on a cash basis. For example, when you buy a new plane, for the next five years you basically show no maintenance cost, and you end up with very high cash flow, very high P&L returns, and also very high ROIC. It doesn’t change the fact that every hour you fly that airplane it is one hour closer to a C check or a D check or major maintenance. The same happens to labour costs. Take the flight deck as an example. A first-year pilot’s pay of say $60,000 a year can rise up to $160,000 for a pilot with twelve-year experience. There are many ways to distort the equation to get a high ROIC for a period of time. It is relatively easy when you are a young and growing airline and you have a high ROIC, but that doesn’t necessarily mean that you are making the right decisions in the long run.
The other interesting disconnect in the airline industry as a whole is that it technically doesn’t make money. Airline business is not a good business for shareholders, but the return on owners’ equity is actually quite good. So, if you look at airline entrepreneurs, people that start airlines and own them, they do quite well because they are able to borrow money and use other people's money, so it is easy for them to do well. They make a few hundred million and then move to the next thing, leaving the problems to someone else. I would like to see longer term metrics that show what it takes to make an airline healthy in the long run.
I also think that we, as an industry, are making a mistake by focusing so much on the aircraft, particularly because their competitive advantage is zero. And it is a trap. You buy the first new planes from an aircraft manufacturer because you think you are going to have a competitive advantage. In about two years lots of airlines will have one. When the price comes down, airlines that don’t have these planes think they have to have them to avoid the disadvantage. There are however airlines that decided not to fall into that trap. They have developed in-house maintenance and modification capabilities to get good use of their older airplanes and are likely to continue with that for quite some time.
JR: In the context of performance measures, why would a low-fare carrier with short turnaround times and no slacks wish to start operating or even moving their base to the congested, Gatwick-like airports risking costly disruptions? At the same time, major legacy carriers are reducing their operation at the capacity constrained airports, finding the opportunities for expansion elsewhere. Is it possible that the desire to expand can be so strong as to ignore the longer-term consequences of such decisions on cost, quality, and reputation? How much does the lack of system metrics contribute to this situation?
AD: Firstly, if you are a low-cost carrier, you are making money by offering places that stimulate demand. You are offering low prices, taking into account how much money people have, and you also have to be competitive.
And the second thing, which I assume is true for most airlines, is that they make most of the money in cities in which they are dominant from the capacity standpoint. In an attractive location, this creates an arms race where you want to become number one as quickly as possible, and you have the potential to make a lot of money in these places, despite the fact that operational performance is very poor.
There is a very interesting point however: do airlines make these kinds of decisions with a full understanding of the operational risk? The answer is almost certainly no. Airlines are making decisions based on long term averages and, to some extent, hopes. These are the rules of thumb. They are not driven by data, nor by any real understanding of operational risk. And, as mentioned in some of your articles, the data is incredibly rich and it’s readily available. For example, I can tell how much a particular plane will be delayed at Gatwick on a given day of the week based on experience. With this understanding, airlines will be designing the schedules pretty much differently. And we will see that airlines operating from congested airports will start readjusting their thinking. But it is a long road.
JR: There are many aspects of quality which are the result of complex interactions between people and processes and cannot be measured in a conventional way. This has become even more difficult considering that quality of service and passenger experience are now mostly dependent on outsourced service providers. As mentioned in your article Buying and Flying, often more than 60 percent of an airline’s cost base goes to suppliers. How do airlines control the quality of outsourced services?
AD: I don’t see any technical reason why an outsourced provider cannot provide as good, if not better, service than the airlines could themselves. I think this is the big issue we face today. There are two different ways to outsource the process. One is to outsource it ‘outcome-based’ and the other one to outsource it ‘input-based’. Typically, in the industry that has very sophisticated operators it is always better to be ‘outcome-based’, where suppliers’ charges are linked to the achievement of defined business outcomes for the customer, rather than being based on input costs such as labour, or outputs such as transaction volumes.
I think that one of the problems we have in the airline industry is that many of the outsourced providers for ground services, ground handling etc, are not particularly sophisticated operators. It is not much about outsourcing or not outsourcing, it is about taking full control of operations and recognising that quality matters. And for me, quality is not just a champagne cork, it also enables us to know things like: was the door opened on time, was the information accurate etc. Quality is not a technology issue, it is an organisational issue and it is a cultural issue. But the data is all there. So that is the problem that has to be solved.
JR: As the gap between the demand for air travel and available airport capacities tightens, passenger experience is deteriorating and affects both the low-fare and Gold customers equally. Have airlines stopped caring much about passengers once the sale is completed?
AD: There are a couple of things that need to change. Firstly, passengers need to be better informed about the risk of missing connections, and secondly, technology needs to be more transparent over passenger choices in general. This is not just about legroom, it is about the chance for a passenger journey to be successful. These changes would start to affect people's decisions and you would see management teams starting to care more about passenger experience. It will take technology to teach customers how to make better choices or how to prepare for an undesired experience.
As for flight connectivity, from an operational standpoint, every management team on the planet would much prefer to make all connections at least one and a half hours long, so that if an inbound flight is a little late you are sure you can still go through security, you can still get your bags, you can still catch the flight. However, if connection time is widened, airlines lose market shares almost immediately. This is because people say ‘I don’t want to spend fourteen and a half hours getting from A to B when there is another flight eleven and a half hours long’. As a result, airlines are building connections that are very, very tight. Your chances of losing the connection if an aircraft is 10min late is very, very high. But the airline won’t be competitive by doing it differently. If this is what customers want, airlines are responding to their needs.
JR: Cheaper fares, more costly, uncomfortable, and anxiety filled journeys, more idle time at choked airports - is it up to the airlines or passengers to change their behaviour?
AD: The next step should be giving the passenger a choice of flight connection while making them aware about the risk of delays and possible loss of connections. I think that ultimately, customers will need to understand that this is mostly about their choices.
Let's wrap up this insightful interview with a few quotes from Alex’s articles:
‘If we look at the airline industry flow of funds over the past 50 years, we see a cycle in which new aircraft-backed debt replaces old debt. The operating efficiencies of the new aircraft helped to create additional cash flow that made it easier to pay off the debt. The result was, yes, positive cash returns—but also mounting debt, with no sign of a cyclical return. Could it be that the airlines in their WACC (Weighted Average Cost of Capital) calculations and measurements of ROIC are overstating the risk and opportunity cost of buying aircraft, but that the banks and lessors are understating the risk and opportunity cost of lending against them?’ (Between ROIC and a hard place: The puzzle of airline economics)
‘For most airlines, a primary factor in recent results has been a windfall from lower fuel prices. Our analysis of IATA data shows that the 2015 global industry operating profit of $59 billion (8.3 percent margin) would have swung to a loss of $6 billion (–0.9 percent margin) if fuel prices had remained at 2014 levels’ (Winter is coming: The future of European aviation and how to survive it)