Air Industry Analysis Essay

Executive Summary Airlines companies are undergoing major changes to cope with the new challenges of the modern economy. Geopolitical factors, such as war and terrorism, the financial crisis of 2009, high entry barriers, as well as extreme weather events, are some of the factors that are driving these changes. Costs in fuel prices, wages and ticket prices are some of the demand drivers of this multi-billionaire industry. Also, there has been an industry-wide shakedown, which will have far-reaching effects on the industry’s trend towards expanding domestic and international services. The perception that air travel is an ordeal continues to grow, making it very difficult for airlines to charge the higher prices that are necessary to return to profitability. Today Airlines provide a vital service, but factors including like the continuing existence of loss-making carriers, bloated cost structure, vulnerability to exogenous events and a reputation for poor service combine to present a huge impedime nt to profitability. While a handful of low-cost airlines have successfully managed to post consistent profits, by and large, profitable airlines are few and far between. Introduction The global airline industry provides transportation to virtually every corner of the world. The airline companies employ many people, hold multi-billion dollar equipment inventory, and generate billions of dollars in yearly gross revenue. It facilitates economic growth, world trade, international investment and tourism. However, the industry can be very vulnerable to government regulations, economic influences, extreme weather events and geopolitical factors such as war and terrorism. The SIC/NAICS code for the industry is 4512 /4811. The NAICS term for the industry is â€Å"Scheduled air transportation† . The industry is further classified into 2 NAICS codes – 481111 for Scheduled passenger transportation and 48112 for Scheduled Freight Transportation. Per NCAIS, â€Å"This U.S. industry comprises establishments primarily engaged in providing air transportation of passengers or passengers and freight over regular routes and on regular schedules. Establishments in this industry operate flights even if partially loaded. Scheduled air passenger carriers including commuter and helicopter carriers (except scenic and sightseeing) are included in this industry.† History The commercial airline industry in the US grew at a fast rate after the World War III. The commercial aviation industry in the United States has grown dramatically since the end of World War II. In 1945 the major airlines flew 3.3 billion revenue passenger miles (RPMs). By the mid 1970s, when deregulation was beginning to develop, the major carriers flew 130 billion RPMs. By 1988, after a decade of deregulation, the number of domestic RPMs had reached 330 billion (Source: Winds of Change). Up to the 1970s the industry was heavily regulated around the world. However, in 1976 under the recommendation of the Civil Aeronautics Board (CAB), the regulatory system was dismantled by the US Congress. Most of the industrialized world soon followed suite. The Airline Deregulation Act passed in the US in 1978 eased the entry of new companies into the business and gave them freedom to set their own fares and fly whatever domestic routes they chose. This lead to a swarm of new entrants, lower fare s and the opening of new routes and services to all over the country. Organization The major Capital expenditure for the airline industry is the cost of the airplanes. Boeing and Airbus are the two major providers of aircrafts to the industry. Other than that the Airports Authorities are the other major service providers to the airline industry. Airline fuel is another major product the the industry buys from external suppliers. The industry itself provides the rest major services- Flight operations, aircraft maintenance, passenger service ( (in-flight food, flight attendants) and Aircraft traffic services (baggage and passenger handling). Governmental Factors As mentioned earlier government factors play a big role in the industry. The growth of the industry post the 1976 deregulation illustrates this point. Government policies that impact the economy also have a big impact on the industry profits as was seen during the 1990 global recession and the 2001 US economic downturn. Wars and Geopolitical tensions that impact the airline fuel supplies also pose threat to the industry. Environmental Factors Environmental factors such as bad weather conditions can force planes to be delayed, canceled or even to divert to another airport. In such cases the airlines are forced to pay for lodging and meals of the affected passengers and in some cases refund tickets. An extreme sample of this is the airline disruption caused by the ash from the volcanic eruption in Iceland in 2010. It could have cost the industry more than $1.7 bln according an estimate by the International Air Transport Association (IATA). Market Structure The airlines industry has undergone major changes since 1978 due to the deregulation and the economic liberalization, where restrictions on the routes and fares charged were removed. Thus in order to obtain the cost efficient and to concentrate traffic to one airport the Hub-and-spokes was created to move passengers from smaller cities and gathered a group of passengers in a major city airport to be transported from a major hub of one city to another major hub. This new system allows the airline industry to retain the oligopolistic market due to the huge barriers that obstruct competition. From one hand the government regulations established barriers for airports such us a slot management system that demonstrate there is a failure in the investment of governments in adequate infrastructure, gate constraints due to exclusive leasing arrangements and gates usage in congested cities is limiting the entry despite the share usage between airlines. â€Å"Airlines need certainty because they have invested billions of dollars in aircraft. They must be certain they will have access to the infrastructure for the next 25-30 years and this is why historic (grandfather) rights are appropriate.† (Airlines International, 2010). On the other hand the hub and spoke system allows major airline firms to restrict the entrance of new competitor, because they have captured the market of small and big cities with a large economy of scale and a big profit margin, price flexibility, and other rights like reserved slots that was very difficult to be matched by new airlines, protecting them from new competitors developing a mature oligopoly where the prices are set by the leaders and the others airlines followed, practicing parallel pricing. All the studies reviewed suggested that despite the benefits of airline deregulation, there are many factors that continued preventing airlines to get advantage of this economic deregulation due not only to the airport restrictions but also due to computer-reservation systems, benefits of frequent-flyer programs, economies of scale of operation. This fact can be evidence after the deregulation when many new airlines attempted to get into the market but the majority failed due to the high cost associated with gates, slots and other airports facilities did not let them to compete with prices as a result this new competitors were acquired by the already established ones. (Seng, 2007) According to RITA, the U.S., Research and Innovative Technology bureau Transportation’s statistics the largest carrier for domestic market from May 2011 through April 2012 was Delta followed by Southwest and American (see table No.1.) It is important to mention that with the merger of United and Continental, they could become the largest carrier if the tendency remains. (Jenkins, 2011) As we can observe, the 55.9% of the market is hold by Delta, Southwest, American, and United,. In order to open the market for new carriers and generate airfare competition the government has to work on expanding the access to new gates, baggage claim areas and slots, otherwise the existent oligopolistic market will continue prevailing. Industry Demand The US airline industry demand is affected by the current market that has generated unstable conditions due to the high dependency and reaction to many factors like regulation, fuel price, inflation, security and competition. In addition this industry was also affected by the financial crisis during 2009 that had a great impact in market demand, thought due to the revival of the economy the travel demand has started improving since 2010. According to RITA â€Å"There were 2.1 percent fewer passengers in the April 2009 to April 2010 period compared to April 2008 to April 2009. From the year ending April 2010 to the year ending in April 2011, system wide passenger numbers on US airlines increased 2.9 percent† (Smallen,2011) As a result of the deregulation of the airline industry in 1979 the traffic of passengers increased and the ticket prices decreased. In this environment there was more competition and less demand, the operating cost and margin profit were affected and the maj or firms filed for bankruptcy falling from six major airlines (united, America, Delta, Eastern, TWA, and Pan Am) to three by 1991 (United, American and Delta). The new challenge for airlines was reconfigured routes and making improvements in capacity and utilization to reach the expected efficiency and offer better service to the general public. Indeed security had a great impact on the demand of airlines. After attack of 9/11 domestic passengers demand went down by more than 30 percent, which caused a reduction on routes and numbers of flights not to mention that planes were grounded and thousands of workers were laid off. To rebuild the public confidence in the air transportation, both airlines and government started working together. These security measures have managed to allay the public fear. According to Bisignani, â€Å" Despite severe shocks in recent years-including the attacks of Sept. 11, 2001, and outbreaks of avian flu-the demand for air travel is at record levels and is expected to grow an average of 6 percent each year for the foreseeable future. People need to fly. More important, people want to fly†. ( Bisignani,200 6) The peak in oil prices during 2008 and the financial crisis during 2009 affected and slowed down the numbers of passengers ,specially leisure travelers, as the prices of oil pushed up fares, and people’s disposable income decreased. The demand for business travel also shifted left. The industry responded with fiercely competing on the airfare which resulted in huge revenue losses and forced major airlines like American Airlines to be restructured. The airline industry overcame this crisis due to people’s need to fly for business and personal purposes and due to the absence of any other alternate mode of long-distance transportation. The use of substitutes such car, train diminishes with distance travelled. This demonstrates that the demand for air transportation is inelastic for longer flights and for business purposes. The lack of substitutes let the airline industry to move without a real external competitor, the passenger trains, bus and personal automobiles are not a viable option for traveling long distances and for business travel. In addition for leisure purposes the demand is more elastic because travelers are more likely to change destination or postpone trips expecting lower ticket prices. Despite the events of security breaches, wars and the economy, the demand for air flight has increased and is expected to continue increasing. The airlines continue to compete among themselves with pricing and offering complementary goods such hospitality, policies, car rental, hotels and tourist packages as the opportunities to improve their sales. Cost structure In the airlines industry, fixed costs are high, while variable costs tend to be low. Costs are fixed and variable at different points in time. That is, the timeframe in this market is important to categorize cost on their relation to output. With the commoditization of air travel, cost structure is now a key success factor in the industry. Central cost items are fuel, capital and wage costs. Costs in fuel prices, which are exogenous as is the time series for the average fuel efficiency of planes; constant dollar amount per seat mile that grows at the rate indicated by the Producer Price Index; and wages, which are based on several factors, such as inflation, industry margins, and average worker tenure. Concerning wages, they are fixed costs in short term decisions and variable in the longer term, where total wage costs change in relation to volume of activity as a result of recruitment, retirement, and dismissals. Consequently, effective management of fuel, maintenance, and labor cos ts is mandatory in the current environment in this industry (Harmsen, 2007). Fixed costs are costs that are unaffected by changes in volume. These costs are always constant even when production varies. One example of fixed cost is rent of premises. In the extremely short term, all costs are fixed, while all costs may be regarded as variable in the very long term, which will be described later, in this section. A good example to illustrate could be long-term leasing aircraft leasing contracts. In the short run the airline would be unable to avoid these payments no matter how it adjusts output. Therefore, lease payment is a fixed cost in the short run, but in the long run they are variable, because contractual obligations will expire (Vasigh, Fleming, & Tacker, 2008). Variable costs are costs that increase or decrease with fluctuations in production. In the aviation market, infrastructure, wear, and the bulk of the fuel are often placed in the variable cost bracket. These normal variable costs are then adjusted by the eï ¬â‚¬ect of congestion, since large load factors add costs from increased services, cancellations, and many other sources. As mentioned on the fore above, costs in the airlines industry are fixed and variable at different points in time. For the purpose of pricing, for instance, a cost structure is required that expresses the time horizon at which different cost categories may be considered fixed and variable. We will describe them with at least three different time spans: medium-long term, short term, and very short term, as follows. * Medium-long term: once the schedule is in place, the costs of operating air services are relatively fixed. This means that capital costs for aircraft, pilots’ wages, technical staff and other skilled labor cannot be influenced. * Short-term: once the carrier decides to embark on the flight, all costs under the medium-long term heading become fixed as do the costs for infrastructure charges (except passenger service charges), wear and the bulk of the fuel. * Very short term: the costs for ticketing, food, travel agency commissions, and extra fuel consumption due to the advent of an extra passenger become fixed once the carrier has decided to accept a ticket reservation. Moreover, wage, capital, and fuel costs are decided to a great extent in markets where it may reasonably be assumed that a single carrier has little influence over prices. Experience shows, however, that major carriers are able to influence all the above costs through negotiation. It is very difficult to observers outside the airline industry to assess the extent of these potential negotiating gains. Analysis of Competitive Forces (Porter’s five forces) The threat of entry by new competitors The threat of entry by new competitors in the Airline Industry is moderate. Being a capital intensive industry, new entrants would require large amounts of money. However, with easy access to bank loans and credit the likelihood of new airlines entering the market has risen. There are still a lot of barriers to entry in the industry. Higher Oil prices would require the airline to operate at full capacity to be profitable and smaller airports do not provide sufficient passenger traffic. New entrants would also have difficulty getting gates at the airports which major airlines use as their hubs. This acts as a barrier for them to operate on more lucrative routes. Major airlines also have stronger brand recognition and have garnered customer loyalty through their frequent flyer programs. Skybus Airlines, Independence Air, ATA Airlines and Maxjet Airways are among the most recent examples of new entrants that have failed to survive in the industry. Even Virgin America, the most successful of new carriers, has so far failed to turn a profit since entering the market 5 years ago. So while entering the new market might be easy, success stories such as that of Southwest & AirTran & JetBlue have been far and few. Pressure from substitute products The pressure from substitute products is weak for the American airline industry. Air travel being the fastest way to travel from one origin to another has no true substitute. Lack of extensive and long distance public transportation system within US reduces the likelihood of someone taking a train or bus to their destinations. Furthermore, time consumption and convenience would also discourage customers to take these options or to drive themselves.However emerging technologies could, in a long run, generate viable substitutes. For instance, more and more companies adopting video-conferencing could impact business travel for meetings and discussions. People could opt for using online chat to virtually meet with their friends and family instead of spending large amounts of money on airline travel. The intensity of rivalry among existing competitor Airline industry is highly competitive as there are several airlines operating on the same routes. These airlines compete by trying to differentiate themselves from others by providing different services – low-fares, frequent flyer membership privileges, no baggage fee, no cancellation fee etc. Competition between the majors and the low-cost carriers has resulted in a downward pressure on the fares, benefiting the travelers but at the same time lowering the revenue for the airlines (see figure). This combined with lower demand and excess capacity has lead to a consolidation trend in the industry. Recent consolidations include – United & Continental, Delta & Northwest and Southwest & Airtran. Such consolidations could lead to monopolization of a market where the majors already rule the roost. The Bargaining power of buyers The buyers are the passengers, for either business or leisure purposes. In the aviation market, the bargaining power of buyers is quite low. The power that airline customers have varies based on the options available to them and the origin-destination city pair. Even though there are high costs involved with switching airplanes, there is not much ability to compete on service. For instance, the seat in one airline is probably not more comfortable than another, unless a potential buyer is analyzing a luxury liner. Other macro environmental trends are the weather, which is variable and unpredictable, and may shut down airports and cancel flights; and airport capacities. Hence, there are pockets where some airlines have pricing power. In this case, the overall airline industry is characterized by significant buyer power stemming from the intense price competition among airlines (Sundaresa, 2009). Since the concentration and size of the buyers in the airlines industry is relatively lower than the number of suppliers it is not difficult to observe that buyers are more aware of the price, product, and services and discounts available at their disposal. The bargaining Power of Supplier The three major inputs for the airline industry are airplanes, labor and fuel. In terms of suppliers of commercial airplanes there are three major Air Bus, Boeing and McDonnell Douglas, it seems like this few suppliers will have great power in the industry but instead they compete between themselves developing technology, capacity of passengers, mechanics training and giving solutions to improve cost effective exploitation of airplanes between others. The second input is labor such as pilots, mechanics, ground personnel and flight attendants , in general they are unionized playing a critical role in the industry. According to IATA â€Å"About half of all workers in the air transportation industry are unionized, 49.3% of workers being union members and 51.6% being covered by collective bargaining agreements in 2006† (http://www.iata.org/whatwedo/Documents/economics/Hirsch_Unions_Wages.pdf) The fuel is an important variable due to the price and its volatility but the market has many suppliers that compete to sell large volumes of fuel but they do not control the price because it is an external factor. (Hirsch, 2007) Conclusion The growth in the airlines industry shows no signs of slowing. The recent industry-wide shakedown will have far-reaching effects on the industry’s trend towards expanding domestic and international services. Despite the events of security breaches, wars and the economy, the demand for air flight is expected to continue increasing. The airlines continue to compete among themselves with pricing and offering complementary goods such hospitality, policies, car rental, hotels and tourist packages as the opportunity to improve their sales. The industry’s challenges for the 21st century are the rising costs of fuel, labor, maintenance and security, the impact of technology, such as telecommunication and video conferencing, as well as bankruptcies and shutdowns. However, the overall perspective of demand has been consistently increasing. Growth rates are not consistent in all regions, but countries with a deregulated airline industry have more competition and greater pricing fr eedom. This results in lower fares and sometimes dramatic spurts in traffic growth. Moreover, in the aviation market, consolidation is a trend. Airline groupings may consist of limited bilateral partnerships, long-term, multi-faceted alliances between carriers, equity arrangements, mergers, or takeovers. In summary, the perspectives for the airline industry are bright and it also holds many challenges. Macro-external environment may directly affect is profitability and operation. Low cost airlines have radically altered the nature of competition within the industry. For low cost, the airlines companies should continue maintaining the existing business model by reducing the cost to improve their product. Turning a profit in a competitive industry with high fixed costs isn’t about gouging consumers on baggage fees. Rather, it’s about paying careful attention to numerous behind-the-scenes expenses, and looking for opportunities to charge passengers for optional extras while keepi ng ticket prices low. References: Lee, Tail (2002). Competitive Airlines. Retrieved July 13, 2012 from http://www.scribd.com/doc/58820847/31/The-cost-structure-of-the-airline-industry#page=53 Pierson, Kawika (2011). Cyclical dynamics of airlines industry profits. Retrieved July 13, 2012 from http://willamette.academia.edu/KawikaPierson/Papers/461653/Cyclical_Dynamics_of_Airline_Industry_Profits Sundaresa, Sankar R. (2009). Introduction analysis of the airline industry. Retrieved July 17, 2012 from http://bcs.solano.edu/workarea/mgarnier/MGMT%2050/Southwest%20Porters%20-%20Brief%202.pdf The industry handbook: The airline industry. Retrieved July 13, 2012 from http://www.investopedia.com/features/industryhandbook/airline.asp#axzz20tWDcbCM Using macro and micro environment analytical techniques provide a comparative analysis of leadership and the external environment for the following four airlines: AirTran, Delta, West Jest, and Air Canada. (n.d.) 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