Will Restrictive Foreign Ownership Finally Lose Its Virginity?

Sky News Online reported that Sir Richard Branson’s Virgin Atlantic Airlines is assessing various merger and/or tie up proposals.  While there is no formal process underway, US carrier Delta Air Lines is rumored to be among the interested.  Sky News City editor Mark Kleinman has learned that “Delta's interest, while at an early stage, may have gone as far as recruiting investment bank Goldman Sachs to advise it.”

Just last week, I was addressing the ACI-NA International Aviation Issues Seminar on the very topic – that we should expect to see a serious push, and hopefully a meaningful discussion among stakeholders, to consider changes to the archaic restriction that limits foreign ownership of airlines.  Whether or not this Virgin – Delta story has merit, I am confident that it will not be the last headline we read regarding tie-ups of airlines with different nationalities in the coming years.  The motivations for mergers or tie ups with various airlines will vary depending on strengths and weaknesses of the carriers involved.

The financial case for this merger activity is quite compelling.  In my presentation, Emerging Markets and Evolving Models: Challenging the Industry’s Structure, I questioned whether the alliance structure is the best operating model to compete with the emerging airline models in Latin America, the Middle East or China.

Some Numbers for Context

Consider earnings.  In 2010 the global airline industry is expected to report a $15 billion profit.  While impressive in absolute terms it represents net earnings of 2.7 pennies for each one dollar in revenue.  This is paltry when compared to other businesses that earn on the order of 6-7 cents and more for each dollar of revenue.  Even with a slow recovery underway, profits for the industry are forecast to decline by 40 percent in 2011, which means that industry earnings are forecast to fall to 1.5 cents for every dollar of revenue generated.  Surely 2010 is not as good as it gets? 

Such slim profits cannot support the 1,500 or so airlines out there for long.  The industry simply needs to be able to consolidate shares of a disparate and a highly fragmented global structure just as steel and autos and shippers have done.  Those industries would certainly not be happy earning 2.7 cents on the dollar if that was as good as it gets.

It is not the mature economies that are expected to grow at high rates, but rather the emerging economies in Asia, the Middle East, Africa and Latin America.  Moreover, it is the emerging airline models serving these regions that are certain to pose serious threats to iconic names like Lufthansa, Air France/KLM, Alitalia, Air Canada, British Airways/Iberia and the alliances of which they are members. 

Just as there is consolidation activity within the US and European airline industries primarily, traffic is consolidating around and among the largest metropolitan centers on the global map.  Competition for this traffic is already vigorous.  Strong brands and strong balance sheets will be required to mine this traffic.  Can alliances be brands?  I think not given the large numbers of airlines that make up these alliances.

According to Airbus, Asian demand is highly concentrated around 11 points on the map:  Tokyo, Osaka, Seoul, Beijing, Shanghai, Taipei, Hong Kong, Bangkok, Kuala Lampur, Singapore and Jakarta, with nearly half of the demand in the Asian-Pacific market traveling between these cities and 91 percent flying to and from these cities.  Given the rapid growth of the low cost carriers in Asia and the Middle East carriers targeting traffic from each of these points, it is clear that individual carriers cannot possibly compete with the emerging low cost juggernauts. So the next question becomes whether the alliances as they now stand could do so either?

Just as capturing and retaining connecting traffic is driving consolidation activity in Europe, flow traffic is the necessary ingredient in making the Middle East airline model work.  The geographic advantage to the Middle East carriers to compete aggressively for global flows is staggering.  Within 2,500 nautical miles of the region lives 36 percent of the world’s population and 16 percent of the world’s GDP.  Within 4,500 nautical miles lives 86 percent of the world’s population and 63 percent of the world’s GDP.  Move the distance to 8,000 nautical miles – the distance where new aircraft technology can and will fly – and the world is virtually captured on a one-stop basis.  North American and European carriers cannot make the same claim.

Today, Emirates’ route map alone covers Asia, Europe, China, the Middle East, the commodity-rich African continent and Commonwealth of Independent States. Ethiad and Qatar serve many of the same points as well.  Will the Middle East airline models under construction be the catalyst for the first global airline merger?

A Financial Case for Global Mergers

Why can industries that serve the airline industry consolidate – often across borders – and the airlines cannot? 

1. Air Traffic Control:  One per country
2. Aircraft Manufacturers:  Two to four providers with 95+ percent market share
3. Aircraft Leasing Companies:  Two providers with 45 percent market share
4. Global Airline Industry:  More than 1,500 providers.  Top 10 have less than 40 percent market share
5. Ground Handling:  Less than three providers at deregulated airports
6. Catering:  Top two providers have 40 percent market share
7. Airports:  Arguably are natural monopolies
8. Maintenance Repair Organizations:  Top five companies have 50 percent market share
9. Global Distribution Systems:  Top three providers have 85 percent market share

The global airline industry’s response to limited foreign ownership has been to create more and more elaborate relationships with partner airlines.  In the "Alliance Phase", we have gone from interline agreements to special prorate agreements to sales incentive agreements to codeshare and blocked seat arrangements to the free sale of code sharing.  Today the industry has evolved into an "immunized joint venture phase" either sharing profits or revenue.  Assessing the level of synergies that can be realized by either a JV or an outright merger, a joint venture only captures 50 percent of the financial potential.

Alliance relationships capture more than two-thirds of the revenue potential from new domestic and intercontinental origin and destination traffic.  The alliance JV’s capture nearly 70 percent of the benefits to be derived from the frequent flyer plan.  But the JV mines very little in terms of cost synergies, arguably deriving only 20 percent.  In addition a merger would permit a full network redesign that would benefit both the revenue and the cost sides of the equation.

While it is true that the size of the three alliances is increasing, the top five carriers in each alliance drive the strong majority of the synergy benefits.  The four immunized JV STAR alliance carriers generate 75 percent of the traffic share across the North Atlantic; the immunized JV carriers in SkyTeam garner more than 85 percent of the North Atlantic traffic; and the immunized JV carriers in oneworld are expected to carry nearly 100 percent of that alliance’s traffic.

Branson Has Reason to Explore His Options

The North Atlantic market is now hyper competitive as all three alliances have anti-trust immunity.  And while Virgin Atlantic is unaligned at this point, I can make a case that Virgin Atlantic’s value increased after AA and BA were granted the ability to form an immunized transatlantic joint business agreement.  Why?  Just like there has been a mad scramble among the three alliances to bolster their respective competitive positions at New York and Tokyo, London cannot be ignored given its importance on global airline map.  And Virgin has slots and a meaningful presence at London’s coveted Heathrow airport.

When you think about it, oneworld is in no position to increase its share of slots at LHR without inciting the envy of its rivals and the harsh scrutiny of regulators, while STAR has British Midland’s slot holdings through Lufthansa.  That leaves SkyTeam.  Delta has been exhibiting a thirst for new Heathrow flying from Miami and Boston (both important oneworld markets).  Delta has also enhanced service to Heathrow from each of its important gateways at New York, Atlanta and Detroit.  But there is only so much Delta can do on its own at LHR.  And there is only so much SkyTeam can do given its slot portfolio.

SkyTeam does not need a hub at London as it already has two of the finest connecting hubs on the European continent in Amsterdam and Paris Charles deGaulle.  In order to compete fully, airlines need to be able to sell on both sides of the ocean. Assuming that there is a modicum of truth to the Delta-Virgin Atlantic rumor, a Delta play at Heathrow is no different than what has been taking place in New York/Newark and Tokyo over the past year.  London’s importance in each alliance’s portfolio is no different.

Singapore Airlines owns a 49 percent share of Virgin Atlantic.  Singapore and Delta have had a long relationship, with both carriers having a cross 10 percent equity stake in a prior life.  Or, Branson may be feeling like he would like to monetize some of his 51 percent holding given the changed competitive dynamics taking place across the North Atlantic and the new and potential competition coming from the Middle East.  Imagine if he were to sell an equity piece to a Middle East-based airline?

The United States and the European Community still have the ownership issue to negotiate per Phase II of the original US – EU Open Skies Treaty.  The Europeans are interested in expanding the ownership levels while the US wallows in labor and Defense Department concerns.  In the past, the US has played catch up with global metamorphosis.  Now is the time to be proactive, not passive, as competition from the Middle East gains ground.

If:

• If vendors serving the airline industry are allowed to consolidate into dominant positions with few border restrictions, and . . .
• If other industries like steel are permitted to consolidate market power around 4 global providers, and . . .
• If the global airline industry has not one dominant player, and . . .
• If Joint Ventures only capture 50 percent of potential synergies, and . . .
• If the five biggest alliance members produce 60 percent of the benefits, and . . .
• If the new and emerging competition is obvious,

Then....

• Why should airlines be hamstrung in their ability to maximize financial performance?
• Why should airlines be forced into Band Aid solutions like alliances when new and emerging competitors are building truly seamless, organic and homogenous products?
• Why should companies that are, or are certain to be, under attack from new competition be prohibited from joining hands to mount the strongest possible competitive reaction?

A far flung alliance formation has less chance to build a global brand than the new and emerging competition.  Imagine a day when the carriers involved in today’s JV schemes are allowed to invest in one another and use the equity capital to homogenize service offerings.

Imagine a day when decades old protectionist thinking gives way to an understanding that the airline industry is a global industry.  Imagine a day when US flag carriers are able to adapt their business plans to the reality that the business is not domestic but rather how the domestic market interacts with the international market?  

Imagine . . .

Again Dear Richard: You Are Not A Virgin Anymore

This article is a repost of a piece written last October.  As Virgin Atlantic boss Sir Richard Branson lobbies President Obama and the US Congress to reject antitrust immunity for American Airlines/British Airways/Iberia/Finnair/Royal Jordanian - I find myself well ........ blown away that a British company should have any say in US competition policy.  US airlines cannot operate as true global companies because of parochial thinking lawmakers like Jim Oberstar.  In case you did not read before, see below.

One of the more amusing bumper stickers I have ever seen/read occurred at an intersection of Woodland Avenue and Jean Duluth Road in Duluth, Minnesota. I was a senior in high school and had been driving for a year and a half or so. The bumper sticker read: Virgins: Thanks for Nothin’.

Last week, Terry Maxon of the Dallas Morning News Airline Biz blog wrote a piece discussing the data analysis that Virgin Atlantic is using to frame the antitrust immunity application recently filed by American, British Airways and Iberia. We will touch on a few of those issues later and in future posts. But first, I have held a late August 2008 interview with Branson done by Karl West of the UK's Daily Mail that I would like to speak to.

West writes that “he [Branson] believes an alliance of the two giant airlines, plus BA merger partner Iberia, would allow them to dictate the market, charging higher prices between Europe and America." This makes no sense to me whatsoever because if it is high prices you are worried about, then who better than your own Virgin Atlantic, to offer lower prices and show the air travel consumer that you are the answer to their high air fare plight.

Your business model takes you to only the largest metropolitan areas, so your pricing actions will benefit the lion’s share of US – London Heathrow (LHR) demand. Because of your “network’s presence” in these large markets, you have, and will continue to have, a strong voice in attracting these customers because your product offering is very good and even different.

Whether it is the US domestic market or the transatlantic market, mature/maturing airline markets have demonstrated time and time again that where competition is vulnerable, a new entrant will exploit that vulnerability. Where there are market opportunities, there will be a carrier to leverage that opportunity. Where there is insufficient capacity, capacity will be sure to find the insufficiency. Simply, if the US - LHR market shows signs of “price gouging” by BA/AA, then surely Virgin Atlantic is among the best positioned to discipline the behavior.

West’s interview was the first one done with Branson following the BA/AA announcement that they would try for an immunized alliance for the third time. Branson believes the 'monster monopoly' will be bad for passengers, bad for competition, and will result in higher ticket prices. “It patently does not make sense,” he fumes. “Monopolies are good for companies, but they are never good for the consumer.” Branson adds: “BA has improved as an airline as a result of Virgin Atlantic keeping them honest.”

First of all where is the monopoly?

To answer that, I turned to Wikipedia for a definition. In Economics, a monopoly exists when a specific individual or enterprise has sufficient control over a particular product or service to determine significantly the terms on which other individuals shall have access to it. Monopolies are thus characterized by a lack of economic competition for the good or service that they provide and a lack of viable substitute goods. Monopoly through integration: A monopoly may be created through vertical integration or horizontal integration. The situation in which a company takes over another in the same business, thus eliminating a competitor (competition) describes a horizontal monopoly (and that is what you are talking about I believe).

Surely no one believes that a monopoly would exist, or even be created, by granting Anti-Trust Immunity (ATI) to BA/AA/IB between the US and LHR. Branson’s arguments are LHR-centric and totally ignore the fact that the airline industry is a network business today and not the cozy structure protected by Bermuda II when Virgin Atlantic first flew in 1984. Yes, LHR is coveted, and is served, by nearly every major carrier of substance from around the world. Those US carriers that were not permitted to serve LHR are now allowed to serve the market and provide Bermuda II incumbents with significant new competition.

But fundamentally, today’s airline industry is about networks and not city pairs. It is a simple fact that oneworld cannot sit and watch STAR and SkyTeam grow anymore. Air France/KLM and Lufthansa/Swiss have grown into the world’s largest revenue producing airlines. Delta and Northwest [completed] will alter the ranking once their merger is approved but that will probably only last as long as it takes Lufthansa to get its hands on SAS and/or Austrian. Branson mentions his thirst for British Midland (BMI) and its extensive LHR slot holdings, but what about Lufthansa’s option on those LHR slots? Surely Richard you are not implying that with meaningful STAR alliance presence at LHR a oneworld monopoly would exist?

Branson talks in the interview about how AA and BA are using the current difficult economic and operating environment to accomplish what they have not been able to accomplish in two prior attempts. Quite honestly Richard, the entire world is being forced to transform their business models to adapt to the new realities.

US carriers are using this time to make difficult decisions on capacity cuts in order to diversify their route structures away from an over-weighted position in the US domestic market. Maybe you should be questioning whether Virgin Atlantic should be considering something other than LHR. Oh you have with Virgin Blue, Virgin Nigeria (and you might sell your stake in that Virgin) and Virgin America.

Or maybe you should be putting more energy into changing the ownership laws in order that Virgin Atlantic can realize all possible synergies from your family of Virgins. Abstinence from industry realities might be safe in the short-term but potentially lonely over the long term. You talk about the AA/BA/IB’s ability to strong arm travel agents and corporate customers. You are a branding genius and now you are saying that you cannot differentiate your product from AA/BA?

At what point do we take you serious?

Your data arguments are weak as well. It is about the local US – London/LHR market and that does need to be studied just as it is done on other deals. At least AA and BA have performed the best analysis to date using the best data source available to make that assessment. The competition authorities will make the same informed analysis and draw the distinction between local and connecting traffic as well.

So go paint your airplanes and while doing so recognize that Willie Walsh is right. He said broken record and I will not take a shot at another of your brands. What I will say is that your arguments are not virgins anymore and maybe you should be writing letters to Oberstar rather than McCain and Obama [which you have]. If you write to McCain and Obama, the subject should be about changing the ownership laws that stand in the way of allowing the industry to become the global industry that rewards world class competitors like Virgin Atlantic. Because the large and small can cohabitate and as you say, make competitors even better competitors.

Oh and while you are thinking about some new arguments, take a look above London. On a clear day, at 40,000 feet, you will see liveries like Emirates, Ethiad, Qatar and others that do not necessarily believe that a network industry requires London to be the center of the airline universe.

Unless you recognize that 1997's arguments need to change the third time around, thanks for nothin’.