The economic challenges of operating an international airline

‘The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines.’

— Warren Buffett

International aviation is an unforgiving business. Pervasive regulation and the underlying economics of the sector mean that normal market forces cannot always be relied upon to arrive at an appropriate level of capacity or sustainable prices. One consequence is that it may be difficult for any particular airline to recover its cost of capital on international routes without some form of assistance. Indeed, many airlines receive substantial government financial assistance, including cheap capital and other forms of subsidies. Ironically, this serves to make a tough business even tougher, because the more efficient airlines do not always prevail. As Robert Baker, former Vice Chairman of American Airlines once said: “Most executives don’t have the stomach for this stuff.”

The supply-side 

International aviation is heavily regulated. Airlines cannot fly to any destinations they choose; instead, access is highly restricted. The right to fly to, through and over other countries is determined between the governments involved, formalised in bilateral agreements known as Air Services Agreements (ASAs). These ASAs determine the terms and conditions under which the national carriers can access routes that begin or terminate in the countries concerned and are based on the ‘freedoms of the air’. They are struck at the government level (where protectionism is often paramount) and inevitably involve a quid-pro-quo, e.g., if an ASA is negotiated between, say, New Zealand and Canada, then:

• Air New Zealand obtains the right to fly to Chile; and
• Air Canada obtains the right to fly to New Zealand.

International aviation is also characterised by very high fixed costs and low marginal costs. Once the right to fly to a destination is obtained, capacity cannot be added ‘one seat at a time’. Instead, when an airline begins flying to a destination it is likely to offer multiple services to increase its market share, chasing the so-called ‘S-curve’ effect.[1] The smallest increment of additional capacity thereafter is a single plane, i.e., an expansion of, say, 300-600 seats. Moreover, because there is likely to be more than one airline serving a route – due to the quid-pro-quos described above (e.g., flights from Air New Zealand and Air Canada) – the result is often a saturation of capacity.  

Unless aircraft can be redeployed from another less profitable route, the fixed cost outlays associated with such step-changes in capacity can be vast. Obtaining a new aircraft from Boeing or Airbus costs hundreds of millions of dollars and the waiting list may be several years if market conditions are buoyant. Obtaining second-hand aircraft may also be difficult if demand is strong – which is generally the case when airlines are seeking to expand.[2] However, once those fixed costs have been outlaid, the marginal costs of operating a particular flight segment are comparatively modest. Overall, this means that:

• international routes are routinely characterised either by too little or, oftentimes, too much capacity; and
• market forces (which are heavily distorted) cannot necessarily arrive at an appropriate level of capacity or a sustainable price level.

The resulting cycles of excess capacity and unsustainable price competition can make it hard for an airline to recover its cost of capital on its international routes. It may simply not be possible for more than a handful of airlines to serve a particular route profitably. Perhaps unsurprisingly therefore, today’s market is dominated by several ‘mega-carriers’ (e.g., Emirates), many of which are government controlled (or have a major government investment). Indeed, many governments mandate a high level of local ownership and control of their ‘designated’ national carrier on the grounds that it contributes to the national interest.[3] Assistance can also be offered in various other ways.[4]

These forms of aid can provide the recipient with significant competitive advantage and a financial cushion that allows it to reduce its price without the need to reduce costs. A number of these airlines, including Emirates, Cathay Pacific and Singapore Airlines have the further advantage that they are ‘mid-point’ carriers operating out of ‘international hubs’, and so benefit from significant before and beyond traffic.[5] The result is a class of airlines that arguably do not compete on a level playing field. Even if an airline is the most efficient, there is no guarantee it will command the greatest market share, earn the highest return or even survive the intense competition that is a common feature of international routes.[6]

The demand-side

These supply-side challenges described above are exacerbated by the increasing price and service sensitivities of modern travellers and the industry’s susceptibility to external events that can evaporate (often already slender) margins. There is an ever-present prospect of exogenous demand-side shocks in the international aviation market that have the potential to severely compromise short-term profitability. The former CEO of Qantas, Geoff Dixon, coined the term: “constant shock syndrome” to describe this phenomenon. International air travel can be affected by events such as: 

• terrorist attacks (the events of 11 September 2001 being the most obvious example);
• pandemics, (some example of which include SARS, bird flu and swine flu);
• volcanic eruptions; and
• the onset of financial crises.

These shocks have the potential to cripple near-term returns, and yet there is little that airlines can do to guard against them. Rather, the cost structure of airlines, and their inability to enter into contracts that commit customers to use the service (as would often be the case for other capital intensive, infrastructure-dominant industries) mean that such shocks have a disproportionately large effect on airline returns, but often not the number of airlines servicing international routes. Meanwhile, international travellers are demanding more and more from carriers, including:

• an integrated domestic and international offering and seamless transition between international legs and onward domestic legs;
• a selection of flight-times, e.g., scheduling, say, one flight per week to a destination is unlikely to be tenable (given the aforementioned ‘S-curve effect’);
• frequent flyer programs that allow them to earn points on other airlines, e.g., travel on Star Alliance airlines can earn Air New Zealand frequent flyer points.

This means that airlines must constantly innovate and invest to improve their product offerings in order to cater to increasingly savvy travellers. It also means that there are likely to be limits to the extent to which an airline can reduce service on marginally profitable or unprofitable international routes and/or abandon routes. Indeed, airlines that have a low share of frequencies on a route risk attaining a disproportionately low market share (the S-curve effect). There may also come a point where cutting back or abandoning international routes begins to affect other revenue streams, such as from domestic routes.[7] 

Solutions?

So how can an international airline respond to this confluence of supply- and demand-side challenges (aside from lobbying for government assistance)? The most obvious response is to try and cut costs. But that can be difficult for airlines with legacy cost bases (e.g., heavily unionised work-forces), which is why one often sees incumbents starting up ‘low-cost’ brands (e.g., Qantas’ Jetstar airline) as a ‘work-around’. Another option is to reduce capacity over the medium- to longer-term and focus on core markets. However, as we have seen, that is a risky strategy – particularly if there is a risk of adverse spill-over effects on returns from domestic networks.

Consequently, airlines have sought increasingly to overcome these obstacles by entering into agreements with other carriers that entail varying degrees of cooperation. These arrangements take many forms, such as interline agreements, codesharing and formal alliances. These sorts of agreements can level the playing field by offering many of the benefits of vertical integration, e.g., more coordinated scheduling, broader networks and more seamless travel and expanded frequent flyer programmes. Indeed, alliances of this kind have now become something of a staple of international airline markets and there is every reason to think that this will continue in the future. 

Hayden Green | Director, Axiom Economics

[1]     Airlines that have a high share of frequencies on a route often have a disproportionately large market shares.

[2]     In contrast, when demand for international air travel is weak, demand for second-hand aircraft also declines leading to over-supply (airlines often end up ‘parking surplus planes in the desert’).

[3]     Many governments mandate a high level of local ownership and control of their ‘designated’ national carrier on the grounds that it contributes to the national interest. This has resulted in a highly fragmented industry where cross border consolidation has been prevented.

[4]     These include direct financial support; easier access to capital; lower tax rates and so on.

[5]     In the case of Emirates, the government is also a major equity investor, the policy maker and the regulator, providing it with a conspicuous advantage.

[6]     Various other factors serve to hinder industry consolidation. For example, several competitors are operating under the clear understanding that the government will be a ‘lender of last resort’ if the airline encounters financial difficulty, e.g., Japan Airlines and, arguably, Air New Zealand. Several airlines have also taken advantage of US bankruptcy protection laws to save themselves from going out of business, e.g., United and Delta.

[7]     For example, cutting international routes will result in an airline losing before and beyond revenue (i.e., from internal domestic flights passengers may need to transit to and from international airports). It may also result in the loss of premium corporate accounts. Indeed, a network carrier needs to be able to meet a high percentage of a major client’s need if it is to retain that business, e.g., a major corporate customer might require an airline to service at least, say, 7 out of every 10 routes that it wishes to fly.