ArchivesAuthor: Vinay Bhaskara

When Southwest Airlines reported its traffic results for December earlier this month, the results once again reflected a recurrent paradox in the US airline industry. Southwest Airlines, which was once the industry’s low-fare leader, recorded unit revenue gains of 7%-8%, its 15th straight month with a unit revenue increase of more than 5%. The carrier achieved these revenue gains despite a 1.8% higher capacity and a 0.3% drop in traffic as measured by available seat miles (ASMs) and revenue passenger miles (RPMs), respectively. For the full-year 2011, traffic grew 6.4% at Southwest while capacity was up 4.9%.

Alongside the announcement of their December traffic results, Southwest also announced that the low-cost carrier (LCC) would be adding a third daily flight between their hubs in Atlanta and Los Angeles, supplementing the two daily flights currently operated by subsidiary AirTran. The additions will bring Southwest’s Atlanta operation to 18 flights a day on Southwest metal, alongside the 200 plus daily flights operated by AirTran.

When Southwest announced its consolidated financial results for the fourth quarter of and full-year 2011 on January 19th, 2012, industry analysts and the carrier were pleasantly surprised, as the results reversed the disturbing trend revealed in Southwest’s 2011 third quarter financial results. In the third-quarter of 2011, Southwest recorded a US$226 million pre-tax loss as opposed to the US$332 million net profit recorded in the same quarter of 2010. Net income swung to a US$140 million loss from a US$205 million profit in the corresponding period a year ago, with the largest chunk of the loss was driven by a US$262 million special charge to settle unfavourable fuel hedging contracts. However, there were other more troubling signs, total expenses jumped 43% to US$4 billion while operating profit dropped from US$355 million to US$225 million year-over-year. Rising costs created a 10% increase in unit costs, driven by the combination of 34% higher per-gallon fuel costs and rises in employee pay.

However, Southwest’s 2011 fourth-quarter results marked a return to profitability for the carrier, and ensured their 39th straight year of net profits. Fourth quarter net income was US$152 million, or US$0.20 per diluted share, up from US$132 million in the same period a year earlier, and beating consensus analyst estimates by around 10%. This profitability also comprised the largest part of Southwest’s full-year 2011 profit of US$178 million, down sharply from the US$459 million net profit recorded in 2010. Southwest Airlines chief executive Gary Kelly said, “Fourth quarter passenger revenues were strong, driven by record yields and continued high load factors. Compared to the prior year, our fourth quarter passenger unit revenues increased 8.2% on a combined basis. Based on current traffic and booking trends, we expect another strong passenger revenue performance in first quarter of 2012.”

Once again, fuel prices were the most significant drags on profitability, with economic fuel costs per gallon increasing 34.7% year over year. This was partially offset by a 9.3% increase in the fourth quarter combined revenues to US$4.1 billion, and a 7.0% increase in unit revenues. Revenue growth managed to make up for the 8.3% rise in unit costs, or a 0.5% increase in non-fuel costs. For the year, capacity was up 26.3%, though a large chunk of that growth came due to the acquisition of AirTran Airways, which was completed in May. Employee costs grew at a relatively slower 19.9% pace, but with former AirTran employees scheduled to receive significant pay raises under their new contracts with Southwest, the overall trend for employee costs is constant increases. For the full year, unit revenues were up just 2.6%. However, Southwest has noticed this trend and committed to stringent capacity discipline in 2012, the carrier’s recently released schedule extension for late August and early September 2012 contains a net reduction of 172 daily flights, even as Southwest takes on many of AirTran’s flights.

Image Courtesy of Southwest Airlines

Not your mother’s Southwest Airlines
Both the financial results and the revenue trends for December are indicative of a paradigm shift that has occurred within Southwest Airlines over the past 5 years. For the longest time, Southwest Airlines had simply grown its way to profitability with a combination of low fares, a no-frills but exciting product, and continuous expansion into secondary US markets. SWA’s business model utilised point-to-point flights between un-congested airports, and relied on quick turnarounds to drive productivity and profitability. In the early 2000s, an additional factor, the carrier’s smart fuel hedging contracts, allowed it to maintain profitability in the face of rising fuel prices that caused significant volatility amongst the other carriers in the US airline industry.

Southwest’s trouble came right around 2007 or 2008, when its history of consistently rising costs finally caught up with growth, implying it had extinguished all of its easy growth opportunities or the so-called “low hanging fruit” by saturating the vast majority of secondary US airports. At the very same time, its fuel hedges, which had allowed them to survive the slow run-up in oil prices between 2001 and 2007, began to run out, thereby bringing Southwest’s fuel costs to parity with the rest of the industry. Meanwhile, the carrier’s famously strong relationship with its heavily unionised workforce precluded concessionary contracts, and employee-driven unit costs continued to rise. Both wage and benefit costs leapt as management sacrificed cost cuts for peaceful labour relations, and the workforce slowly began to age. Meanwhile, a traditional advantage of Southwest’s costs: the defined-benefit pension plans that burdened its full-service competitors, were wiped out by Chapter 11 bankruptcy reorganisations similar to the process started by American Airlines and its parent company AMR Corporation in November 2011.

As Southwest was grappling with its rising costs, a host of new nimble low-cost competitors emerged, eager to steal market share from Southwest. Carriers like JetBlue, Allegiant, Spirit Airlines, and Frontier Airlines all utilised unique business models and lower costs to attract Southwest’s typical constituency of leisure travellers. Thus it was inevitable that Southwest’s business model would have to change.

In early 2007, Southwest began to take notice of these troubling trends and took action, it rebuilt its entire business model to cater to the business travellers. Revenue generation became their greatest priority, ostensibly to offset rising costs. Slowly but surely, the carrier began to soften its rigid focus on running efficient operations through secondary airports.

The first step change occurred in Southwest’s network strategy. For the longest time, Southwest had avoided many of the larger airports in the Northeast, such as New York John F. Kennedy International Airport, New York LaGuardia, Newark Liberty, Philadelphia, Boston, Washington Reagan Airport in favour of alternatives: Islip, Manchester, and BaltimoreWashington. But recognising that these are among the most powerful business destinations in the country, Southwest swallowed its typical derision for business airports and began actively targeting expansion into the congested Northeastern airports. Southwest rapidly built up a quasi-hub in Philadelphia, challenging incumbent leader US Airways with up to 80 daily flights at operational peak. Moreover, it expanded into slot-restricted airports like New York LaGuardi through a purchase of slots from the now-defunct American Trans Air (ATA) and Washington Reagan National Airport through the merger with AirTran. Electing to sacrifice some of its industry-leading productivity, Southwest also moved into congested legacy airline strongholds like Boston and Minneapolis St. Paul. These efforts resulted in significant revenue appreciation and additional corporate traffic and contracts. But it also caused a significant drop in the airline’s vaunted productivity, with productivity in a variety of measures dropping 6-8% between 2007 and 2011. Increased delays at congested airports, as well as at Southwest’s new hubs, also cutbacks on Southwest’s once stellar on-time performance (OTP), with Southwest finishing dead last in OTP amongst major US carriers in 2011 according to Flightstats.com, an independent firm measuring airline operational performance.

Southwest’s business model also shifted at existing airports. Whereas Southwest had once solely operated point-to-point flights, it began to offer more and more connections in its large existing airports like Chicago Midway and Baltimore-Washington. Indeed, according to a 2010 report from aviation consultancy Boyd Group International, 9 large Southwest Airline operations: Chicago Midway, Baltimore-Washington, Houston-Hobby, Nashville, Dallas-Love, Denver, St. Louis, Phoenix, and Las Vegas, saw more than 25% of their traffic bases composed of flow, or connecting traffic. The largest percentage of connections occurs at Chicago Midway, where a full 43.2% of passengers were connecting to separate flight. On a network-wide basis, according to Southwest spokeswoman Brandy King, between 70%-75% of customers fly non-stop on Southwest, meaning that connections number 25%-30% of Southwest’s passengers. Southwest’s largest operations actually look very similar to legacy hub operations in smaller airports such as Delta Air Lines in Cincinnati or United Airlines in Cleveland. Southwest’s commitment to a changing model was seemingly validated by their merger with Atlanta-based AirTran Airways, whose central hub in Atlanta serves 67.3% flow traffic, with smaller but still significant totals at its other hub operations in Baltimore and Milwaukee.

Air Tran integration poses network challenges & opportunities
Despite the subtle long-term shift from point-to-point to connecting traffic, Southwest’s business model still operates on the other end of the spectrum from AirTran. Southwest’s outstations typically require a minimum of 8-10 daily flights for viability in order to spread airport costs over enough flights, whereas AirTran sometimes operates just 1 or 2 daily flights per destination. According to Southwest Airlines spokeswoman Brady King, “We plan to integrate the AirTran network into Southwest over the next few years, and plan to evolve the AirTran market into a Southwest point-to-point model. We don’t have a percentage that we are working to reach, just a natural integration of the two carriers that transitions AirTran over to Southwest’s style of operating”. This plan was directly illustrated in Southwest’s recent schedule announcements, including its plan for further 2012 integration between AirTran and Southwest.

As part of Southwest’s continued merger integration, Southwest has worked to eliminate service to small and/or marginally profitable airports, many of which rely on connections over the carrier’s hubs. “Effective August 12, 2012, AirTran Airways will cease operations at the following airports: Allentown, Pa. (ABE); Lexington, Ky. (LEX); Harrisburg, Pa. (MDT); Sarasota, Fla. (SRQ); Huntsville, Ala. (HSV); and White Plains, N.Y. (HPN). AirTran currently operates six daily non-stop flights at Sarasota with 16 employees. Its Allentown (one daily non-stop flight), Lexington (two daily non-stop flights), Harrisburg (one daily non-stop flight), Huntsville (two daily non-stop flights), and White Plains (three daily non-stop flights) operations are all supported by AirTran’s contracted vendor partners.” These airports, with the exception of White Plains which is slot restricted, possess primarily leisure travel bases, and provide limited ability for Southwest to upscale with more flights on larger aircraft. The last factor is especially important because much of Southwest’s fleet of smaller Boeing 717 aircraft inherited from the AirTran merger comes off lease over the next 5 years, with some analysts predicting that Southwest will eliminate the relatively inefficient fleet entirely before that point.

Meanwhile, 22 AirTran markets will retain their service for the time being, and are planned to convert to Southwest services in the near future. The fate of the balance of AirTran’s destinations has for the most part been determined, with 53 of the carrier’s 69 destinations planned for conversion to Southwest operations. Under this plan, the first joint destination to be solely converted into a Southwest operation is Seattle, where the carrier will offer up to 41 peak-day flights.

The commitment also involved several international destinations including, “Punta Cana, Dominican Republic (PUJ), Cancun, Mexico (CUN), Montego Bay, Jamaica (MBJ), Aruba (AUA),  Bermuda (BDA), and Nassau, Bahamas (NAS).” Mexico City and San Jose Cabo will also be getting Southwest service, with the carrier announcing a slew of routes to those destinations in late 2011, as well as applying to serve Cancun from Denver and Austin in early 2012. This expanded international flying marks a departure from the traditional Southwest model of domestic flights only, and will require Southwest to alter its reservations system substantially to include such flying.

Potentially more lucrative are the new opportunities brought to Southwest by AirTran, as well as the shift in business model the merger has caused. AirTran holds a valuable slot portfolio at both Washington-Reagan and La Guardia, which Southwest can utilise to improve its standing with business travellers. Southwest has already begun to transition these operations to more profitable airports like St. Louis and Denver from New York LaGuardia. International business also looks set to grow, with Southwest recently indicating that it wants to start international operations from quasi-hub Houston-Hobby. Hobby currently lacks FIS facilities with Houston’s international flights being handled by further away George Bush Intercontinental Airport, a hub for competitor United Airlines, but would provide business travellers with a convenient alternative to Bush Intercontinental for international travel, primarily to Mexico and Central America.

The expansion of the destination base provided by AirTran can only help Southwest’s ability to acquire lucrative corporate traffic agreements. This effect is likely to be most pronounced in mid-sized and large cities such as Memphis, Charlotte, and Washington Reagan. On the downside, Aspire Aviation is doubtful of Southwest’s ability to maintain services in small airports like Key West, Flint, and Branson (MO), and feels that a suspension of these destinations is likely in the longer term. Thus integrating AirTran’s network with Southwest is likely to be very difficult, especially in terms of appreciating AirTran’s unit revenues to match Southwest’s.

Image Courtesy of Andertho

Atlanta Southwest’s biggest challenge
And nowhere will Southwest face greater difficulties in achieving integration than in Atlanta. In 2011, Gary Kelly was quoted as stating that Southwest expected to grow Atlanta revenues by at least US$2 billion over the next 3-4 years. However, Southwest will face significant challenges in achieving such gains, for a myriad of reasons.

The first is AirTran’s competitive position in the market, as well as the nature of the entire operation. Southwest has already announced a number of changes to the combined carrier’s operation in Atlanta, dropping numerous flights to smaller destinations, while adding flights to other markets, primarily Southwest strongholds, including Austin, Norfolk, and Louisville, destinations that lacked service from Atlanta on AirTran. All told, in August of 2012, Southwest will operate 28 daily flights to 11 destinations from Atlanta, with AirTran flight levels at around 170-180 per day.

Southwest will primarily suffer from AirTran’s current competitive position in Atlanta. With over 67.3% of passengers connecting in Atlanta, AirTran’s operation there is not as heavily dependent on origin and destination (O&D) traffic as most of Southwest’s largest ones. But with Southwest cutting smaller destinations to focus on larger cities, AirTran’s secondary competitive position in Atlanta’s O&D markets is a significant hindrance to integration plans.

Aspire Aviation reviewed origin and destination (O&D) data from the United States Department of Transportation (DOT) for the second quarter of 2011 in Atlanta, and it is startling to see just how effective Delta Air Lines has been at competing with AirTran on key Atlanta markets. The table below lists some key metrics in the 50 largest O&D markets from Atlanta for the second-quarter of 2011. The most striking feature is the stunning dominance of Delta in these markets, of which the SkyTeam alliance member is the market share leader in 47 of the 50 markets. Delta’s position as the lowest fare carrier in many of these markets show how aggressive they have been in matching fares offered by AirTran to be sure. But there is also strong evidence that Delta has managed to recapture pricing power on many of these routes, while simultaneously retaining its dominant share of O&D traffic. In 27, or more than half, of these top 50 markets, Delta is the market share leader for O&D passengers while AirTran is the lowest fare carrier. In these markets, Delta holds on average, about a 20.7% fare premium, and across the whole 50, holds about a 2-to-1 advantage in O&D market share versus AirTran.

On its network as a whole, AirTran’s revenues would need to appreciate 8%-12% to achieve parity with Southwest’s unit revenues. But in Atlanta that effect is even more pronounced. Southwest will face an uphill battle in appreciating AirTran’s revenues, and in achieving the US$2 billion of revenue gains. There is very little room for Southwest to enact the famed “Southwest Effect,” because AirTran has already stimulated most of these markets as far as it can go, with its position as the lowest fare carrier in 29 of the top 50 being a testament, and as such cannot achieve revenue gains through volume growth. In fact, with AirTran’s unit costs likely to rise appreciably in the face of its merger with Southwest which has much higher labour costs, many of these markets are likely to contract somewhat as fares naturally rise. Further hampering Southwest’s troubles will be the loss of baggage fee and other ancillary revenues in Atlanta. For full year 2011, such revenues, which AirTran has continued to collect while operating as a subsidiary of Southwest, even as the parent has launched a huge advertising campaign centred on its lack of bag fees, were between US$100 and US$130 million annually in Atlanta, according to Aspire Aviation estimates. This revenue will be lost as AirTran is slowly integrated, and will have to be made up to maintain profitability at the hub.

Southwest acknowledges some of these challenges, but chief executive Gary Kelly is confident of its success. In the carrier’s fourth quarter and full year 2011 analyst’s conference call, he stated; “Well, I’m not sure that I have anything new to add to the discussion. We feel like, and so does AirTran, we feel like we can add value to the Atlanta discussion. We can win customers in Atlanta. We can take existing Southwest customers to Atlanta. We can certainly significantly restructure the AirTran schedule and take advantage of the Southwest network, and that’s what we’re focused on doing.”

However, Aspire Aviation feels that Southwest’s situation in Atlanta is far more precarious, primarily due to the effectiveness of its chief competitor, Delta Air Lines. Delta Air Lines, perhaps as part of its heritage from Northwest Airlines, is a ferocious competitor with low-cost carriers (LCCs). Delta’s effectiveness in competing with AirTran has been noted above, but equally important has been its success in dealing with intrusions from Southwest before. For example, in Salt Lake City, Delta’s western hub, Southwest actually bought a carrier with a Salt Lake City hub, Morris Air, in 1994. However, over the next 10 years, Delta competed so vigorously for control of the Salt Lake City market that Southwest withdrew from many former Morris Air markets. Today, Southwest is less than one-tenth of the size of Delta in Salt Lake City, whereas its operation was one-third of the size of Delta’s in 1994. A similar pattern has occurred in former Northwest, now Delta strongholds Detroit, Minneapolis, and Memphis, as well as in key Delta markets such as Cincinnati. In the former two, Southwest has only a token presence, and never served the latter despite Memphis will come online as part of the AirTran merger.

Moreover, Delta Air Lines has several advantages over Southwest. Corporate traffic in the region skews heavily to Delta, which has a much larger global network than AirTran or Southwest, especially when one considers Delta’s membership in the SkyTeam alliance. This corporate traffic base buys heavily on Delta for its leisure travel, and is especially enticed by Delta’s strong frequent flier programme, while retaining a strong personal loyalty to the Delta Air Lines brand. With Southwest transitioning from AirTran’s point-per-flight model to Rapid Rewards’ point-per-dollar spent model for frequent fliers, Delta’s mileage/point-per-flight model could steal away many AirTran frequent fliers from Southwest. Another factor that could shift traffic from Southwest to Delta is the product difference with AirTran. In Atlanta, AirTran has over time built up a strong following for its unique product that offers business class seating with its resultant amenities, as well as assigned seating. Delta offers these amenities, plus in-flight WiFi, and in-seat video entertainment on a majority of its Atlanta flights. Southwest Airlines, on the other hand, offers only a single class of seating, open seating that is done by groups but still essentially a limited free for all, passengers have no guarantee of an aisle seat, for example, and limited but growing in-flight WiFi. Passengers looking for a premium product will likely move to Delta simply via attrition, affecting Southwest’s ability to attract lucrative business travellers.

Make no mistake, this is not to say that Southwest cannot compete with Delta in Atlanta, with Southwest’s no checked baggage fees is expected to have a stimulatory effect on the transfer of unaligned leisure passengers from Delta Air Lines to Southwest. And for the average economy class passenger will actually see increased comfort as AirTran’s 737-700s and 717-200s are reconfigured in the Southwest configuration. But the combination of effects means that there is limited scope for Southwest to achieve the broad-based origin and destination (O&D) unit revenue gains required for Atlanta to be profitable on the Southwest scale. Thus in the near term, or in the next 2-3 years, Southwest will have no choice but to maintain Atlanta as a “connect-first” operation, with a connection to O&D ratio of at the lowest 55/45 split. Even longer term, Southwest will likely be unable to ever bring connections in Atlanta down to around 45% of Chicago Midway. This is troublesome because of Southwest’s persistently increasing unit costs. From 2000 to 2010, Southwest’s unit costs rose from 77% of those of Delta’s to 95% of those of Delta’s, and even with recent increases at Delta and a growing appetite for cost discipline at Southwest, the two carriers are likely to have similar cost profiles over the next 5 to 7 years. This ramp-up from AirTran’s lower cost base will afford Delta Air Lines additional pricing power in the market and Aspire Aviation thinks this will boost the profitability in what is already Delta’s most profitable hub, according to that carrier’s fourth quarter and full-year 2011 earnings call. The unspoken reality is that Southwest Airlines, despite its fearsome reputation, might actually be easier for Delta to compete with than AirTran ever was.

Image Courtesy of Southwest Airlines

Product investments culminate in “Evolve” seats
Beyond its network strategy, Southwest Airlines has also enacted a string of recent product enhancements, targeted primarily at enhancing revenues. Moves such as increased amenities for the “Business Select” product, as well as the introduction of in-flight wireless connectivity unquestionably enabled Southwest to improve its income streams. However, its most recent announcement of the new “Evolve” in-flight seating was, in Aspire Aviation’s opinion, intended to substantially lower Southwest’s unit costs.

Earlier in January, Southwest announced a new seating configuration for its fleet of 370 Boeing 737-700 aircraft, which would increase seat counts from 137 to 143 seats in single-class configuration. The capacity up-gauge is enabled by the usage of new slim-line seats, as well as a reduction in recline and seat pitch by one inch, whose combined effects allowed Southwest to add an extra row of seats.

The new configuration will be placed on all current Southwest Airlines 737-700s. As AirTran’s 737s and 717s slowly are converted to Southwest operations, the combined carrier will also evaluate utilising “Evolve” seating in these aircraft. 737-300s and 737-500s will not be retrofitted with “Evolve” as they are scheduled to be replaced by a mixture of Boeing 737-800s and Boeing 737 MAX 8s over the next decade, both of which will utilise elements of “Evolve” seating, as well as the Boeing Sky Interior.

Southwest touts that the, “improved durability of the redesigned seat coupled with fuel savings from 635 pounds less weight per aircraft is expected to result in more than US$10 million in ongoing annual cost savings.” However, in Aspire Aviation’s view, that figure underestimates the true cost savings of the configuration change. Adding 6 seats represents a 4.4% increase in capacity on every flight operated by a 737-700. US$10 million are essentially the direct savings due to lower weight and the resultant drop in fuel burn per seat. However, Aspire Aviation feels that the capacity up-gauge will limit the increases in Southwest’s unit costs, putting downward pressure on cost per available seat mile (CASM) while simultaneously allowing increases in unit revenues and total revenues due to the relatively inelastic nature of Southwest’s demand profile when compared to other ultra low-cost carriers (LCCs). In fact, Aspire Aviation estimates that the effect of “Evolve” seating on Southwest’s CASM is to decrease it by 1.7%-1.9%, or US$0.14-0.15 cents, holding other factors constant. In addition, Aspire Aviation estimates the “Evolve” seats would increase Southwest’s operating margin by 0.2-0.4 percentage points.

Southwest continues to delay the inevitable showdown with employees
Between the increase in 737-700 seat count, and the addition of 175-seat 737-800, which is the largest aircraft in Southwest’s history, Southwest Airlines using its fleet to naturally push down unit costs. But the fact remains that Southwest’s unit costs have been tracking upwards for a long time. Having lost its advantage in fuel costs in earlier this decade, Southwest’s unit costs are now actually comparable to those of the full service carriers in the US, although those carriers have had the benefits of shedding costs in Chapter 11 bankruptcy protection.

Equally evident is the correlation between increasing employee costs, and the rise in overall unit costs. In fact, labour costs now represent about 15% of the overall cost per available seat mile (CASM) growth, with fuel prices that are not in the control of the company after the expiration of its hedges, comprising the balance of the rise.

This trend of unchecked growth in employee compensation can have disastrous long-term effects on Southwest’s profitability. The company to an extent acknowledges this, with Gary Kelly noting in a December letter to his employees that, “Our labour rates are now, far and away, the highest in the industry. Through bankruptcy, very large new airlines have emerged with lower rates than us and better productivity. Next to fuel, labour is our highest expenditure. We can’t have lower overall operating costs if our labour costs aren’t lower. We can’t have lower labour costs if we aren’t more productive. The good news is that we have a lot of opportunities to improve our productivity, eliminate waste, and preserve our pay rates and benefits for the foreseeable future. It’s crucial that we take advantage of those opportunities.”

This letter was sent out in response to the Chapter 11 bankruptcy filing by American Airlines in late November, and Kelly also warned that American’s lower costs would be especially troublesome for Southwest, as the two carriers overlap in about 30% of Southwest’s capacity. However, it is equally clear that Kelly does not necessarily have the stomach to truly confront the labour cost issue head-on. Recapturing lost productivity is a great ideal to strive for, but only wage cuts or freezes would reduce labour costs down to the levels at their legacy peers. To be sure, there is certainly a valid rationale for Southwest’s actions in this regard. Southwest has always enjoyed a superb relationship with its heavily unionised employees and hence the persistently rising pay rates. Moreover, Southwest’s employees are amongst its most valuable assets, they make possible Southwest’s strong productivity and their quirky and unique approach to in-flight service is frequently cited as one of the industry’s best. From top to bottom across all of Southwest’s employee groups, their superb customer service ethic has resulted in Southwest garnering one of the best service reputations in the industry, with the fewest passenger complaints per capita of any major US carrier, despite having a poor statistical customer service record, baggage lost, delays, on-time performance, and the likes. Therefore, it is understandable that Southwest’s management is loathe to change the status quo with its unions, in fear of adversely affecting customer service.

However, there will come a time when Southwest will have to confront its employees with pay reductions as the rest of Southwest’s costs are simply too volatile. An interesting prism through to view Southwest’s shifting business focus and fleet moves is that they allow Southwest to delay this final confrontation with its employees. Of course revenue growth and fleet manipulation would have likely occurred regardless of Southwest’s employee costs, but the order in which they occurred certainly lends credence to this theory of an inevitable eventual showdown over labour costs. The issue lies in the fact that revenue growth is finite, demand for air travel is becoming more and more price-elastic over time, and as such, Aspire Aviation estimates that under current conditions, Southwest could probably grow passenger yields by another cent or so before growth flattens out. The fleet manipulation is also limited, both by capital, and by pure results. However, between these two effects, Southwest should have 3-4 years of breathing room before having to deal with its employees. At any point during this period, Southwest could strike a deal with its employees. However, Aspire Aviation thinks that it is more likely that Southwest will choose to further delay the final confrontation with the employees, and instead enact a drastic change in its business model. Southwest has limited ability to affect its non-labour costs beyond current plans, so it ultimately comes down to 3 options to expand revenues: international long-haul flights, converting to two-class seating, or adding checked baggage fees.

The first two options are both capital-intensive, with the former also representing a remarkable shift away from Southwest’s single fleet model, and requiring the latter to generate sufficient revenues. Thus, checked baggage fees, while controversial, would allow Southwest to most effectively increase net revenues. In fact, baggage fee revenues are typically around 95% profit, and are untaxed by the federal government in the United States.

In the short term, Southwest has committed to not charging baggage fees, even launching a widespread “Bags Fly Free” advertising campaign centred on the theme. However, Aspire Aviation believes that over the longer term, the upside of huge potential revenues is simply too large to ignore. Charging a checked baggage fee would not be without consequences for Southwest, after the carrier has repeatedly stated that it has seen upticks in market share and position since the rest of the industry with the exception of JetBlue Airways added such fees. It would adversely affect Southwest’s excellent customer service reputation and would likely result in some leakage of travellers to other carriers. Furthermore, over the next 3-4 years, passengers are likely to become more de-sensitised to checked baggage fees as they will be forced to pay them when flying other carriers.

But in the same vein, the additional revenue gained would be very lucrative. Utilising a “back-of-the-envelope” calculation method, Aspire Aviation has roughly estimated the revenues Southwest would have received in 2011 from baggage fees. In 2011, Southwest carried roughly 104 million revenue passengers. Assuming 5% leakage to other carriers because of the fee, and using the figures for flow versus origin and destination (O&D) passengers given to Aspire Aviation by Southwest Airlines, and assuming that around 70% of passengers check baggage at US$25 a bag, Southwest would have received roughly US$1.47 billion dollars worth of baggage fee revenue. Even that figure is conservative, as AirTran manages to get close to US$30 worth of ancillary revenue per revenue passenger whereas Southwest Airlines in this scenario would only be getting about U$15 per passenger.

Thus, Aspire Aviation believes charging a checked baggage would allow Southwest to continue to reward its employees for their efforts, while ensuring profitability with minimal investment.

In conclusion, Southwest obviously has a tonne of decisions to make over the next few years, and the good news is that it does have a decent period of time. The transition from Southwest to AirTran will undoubtedly raise the latter’s cost profile, thereby necessitating the elimination of formerly profitable flying like the service to Sarasota, whose withdrawal greatly angered airport management. A tough battle lies ahead in Atlanta, where Aspire Aviation remains sceptical of Southwest Airlines’ ability to easily generate large revenue gains. Moves such as “Evolve” seating and adding checked baggage fees may debase the passenger experience to a certain extent. But from a long-term point of view, these initiatives are imperative to boosting Southwest’s profitability, and can prevent Southwest from having to go through a similar stage of employee cuts as American Airlines which plans to cut 13,000 jobs during its bankruptcy process.

Starting from January 26th, US air travel consumers will notice advertised fares for domestic travel appreciating significantly, as new rules mandated by the United States Department of Transportation (DOT) take effect.

When the DOT announced a set of new “consumer protection” rules earlier this year, airlines predictably voiced their fierce opposition, especially to the new policy on taxes. Airlines will now be required to advertise fares with all government taxes and fees included, whereas previously, they were allowed to separate these from the basic airfare until final purchase. Taxes and fees typically make up around 20% of the cost of a normal economy class domestic ticket, and according to the DOT, consumers view delaying the disclosure of mandatory taxes and fees till the end of purchase as “bait and switch” tactics.

“In order to understand the true cost of travel, consumers need to be able to see the entire price they need to pay to get to their destination the first time the airfare is presented to them,” said the DOT in the final rule.

Southwest Airlines, Spirit Airlines, and Allegiant Air have all filed appeals to have the rule overturned in the US Court of Appeals in the Washington D.C. circuit, claiming that the rules violate commercial free speech rights. They also feel that airlines are being unfairly singled out for such practices.

Image Courtesy of United Continental Holdings

“Our main objection… is that there is no justification for treating air travel differently from just about everything else that consumers purchase, i.e. they pay for the price of goods and services and then pay tax. And that is how everything is advertised, as the price of the item separately from the tax on that price,” said Southwest Airlines spokesperson Brandy King via an e-mail widely disseminated to American media.

From a purely legal standpoint, the airlines are correct in claiming that they are being somewhat singled out. Many businesses do not include government taxes in their advertised price of goods. For example, automobile dealerships often advertise their cars at one price, before tacking on thousands of dollars worth of sales tax once actual negotiations with customers begin. On the flip side, the federal petrol tax is included in the price signs posted by various gas stations, though there is little to none actual advertising of petrol prices, only the ancillary services provided by the station.

However, US consumers have been conditioned into expecting low fares by years of cheap oil, foolish capacity addition by existing players, and unsustainable new entrants. In fact from 1995 until 2009, real US airfares which are inflation-adjusted dropped more than 26.6% before rising to narrow the gap to around 16.6%, the US Department of Transportation (DOT) Bureau of Transportation Statistics (BTS) says. Meanwhile, according to Airlines 4 America (A4A), the formerly Air Transport Association of America (ATA), a roundtrip domestic airfare only increased by 70% from 1978, the year when the US airline industry was deregulated, to 2010, whereas the consumer price index for all urban consumers rose by 234% over the same period, implying airfares in real terms have become considerably cheaper. It is that recent rise in fares, coinciding with the current economic stagnation in the United States, which has particularly angered consumers. When airlines throw on an extra 20% in taxes and fees over an already higher fare, to many it becomes the final straw.

Other rules speak to the frustration of US travellers with the recent spate of ancillary products unveiled by US carriers. Previously included in the cost of buying a ticket, things like baggage, food, and changing reservations have drawn increasing charges from airlines. By separating such services out from advertised fare prices, airlines are able to suck in customers with cheap fares, making money through all of these ancillary charges. As an added bonus, such ancillary charges , worth roughly US$5.7 billion to American carriers in 2010, are not taxed whereas fare revenue is. Indeed, such ancillary charges have become a major part of US airline business models and the sector’s recent profitability.

But along with the success has come an outpouring of anger from American travellers, who feel entitled to check their bags and change reservations for free. Despite the fact that airlines are simply customising their products into an a la-carte model not unlike that of restaurants and other service-oriented businesses. When one walks into a McDonald’s, for example, he or she is able to mix and match the individual food items to create an ideal meal: fries, salad, and a drink, or burgers, ice cream, and chicken nuggets. In a perfect world, this would be how the air travel system works, passengers can pick and choose the service options they want, just the flight from point A to point B, or a smorgasbord of travel options with lounge access, priority boarding, checked baggage, and more. The integrated model of yesteryear that integrated all of these ancillary services was more akin to standard set meals: one received a rich 5-course meal, even if all he or she really wanted was a snack-to-go. US consumers have warmed to the former a la-carte model in almost every industry except the airline industry, they still want the 5-course meal, but for the price of a large soft drink.

This frustration has manifested itself in a trio of rules from the DOT including:

• The same baggage allowance and fees to apply throughout a passenger’s trip
• A 24-hour window for passengers to hold or cancel a reservation without payment or penalty for reservations made a week or more before the departure date
• Required disclosure of baggage fees upon booking and on e-ticket confirmations

These rules have not generated nearly as much opposition from US airlines, though the second one could eliminate a minor revenue stream. Such rules are in fact tamer than the ones they face in operations to Europe, which has more stringent consumer protection standards than does the United States. Thus, the financial impact of these rules on carriers will be minimal, though the second could take a little wind out of Southwest Airlines’ “No Change Fees” advertising campaign.

The final two major rules are also relatively benign:

• Required prompt notification of delays of more than 30 minutes, cancellations and diversions
• A ban on price increases after a ticket has been purchased

Neither rule is particularly troublesome though they do represent additional costs. The second rule could spell the death knell for a plan mulled by Allegiant Air that had called for passengers to pay a base fare upon purchase, and then a variable fuel component that rose and fell with the price of oil.

Elsewhere in the world of fees, Delta Air Lines announce that it would adding a US$3 surcharge each way on fares purchased for transatlantic travel after January 2nd, 2012 in response to the new emissions trading scheme (ETS) for airlines launched by the European Union (EU). It became the first major US carrier to implement such a surcharge, but if the backlash is minor, its competitors are expected to follow suit. US$3 is not very much on typical transatlantic one-way fares of US$500 or more, and it for the moment invalidates some of the claims by industry analysts that the ETS would add US$50-$90 to the price of each ticket. Still, the scheme is in very early days, and as the caps get more stringent over time, the cost of compliance is undoubtedly going to rise. But in the short-term, the actual fiduciary effect of the ETS will be negligible.

Image Courtesy of Delta Air Lines

Chinese carriers have taken the opposite tack and flat-out refused to pay the tax. This action could be a prelude to a very interesting diplomatic battle that will have the US airlines closely watching. Estimated cost of compliance over 15 years for US carriers is more than US$3 billion, but the fast-growing Chinese market could see its growth capped as well. China is negotiating from a position of economic strength given all of the recession concerns in Europe. If the China Air Transport Association (CATA) chooses to make an issue out of this, then it is hard to see the EU doing anything but backing down in light of its recent economic troubles.

European carriers, whom industry body International Air Transport Association (IATA) has projected to lose US$600 million in 2012, will more acutely feel the pinch. Lufthansa warned in a statement Tuesday, that passengers could expect to see significant new levies on account of the ETS. The carrier further stated that, “The incorporation of airlines in the EU emissions trading scheme means that European operators are now facing additional costs which will make flying within and via Europe more expensive for passengers. It will also distort competition and impact on the sustainability of the aviation industry.”

For US consumers, it is somewhat likely that air fares will rise beyond the effects of ETS and the new rules. For 2011, the great paradox has been that unit revenues have consistently risen despite stagnating economic growth. Capacity discipline, almost always sorely lacking amongst US carriers, has blossomed with a vengeance, and if carriers were to maintain such prudence in 2012 as they have indicated they plan to and are likely to do so, then fares should naturally rise, so long as the US economy maintains its current course. Of course, the threat of European debt default and a resultant recession is always prevalent, IATA described this as a worst-case scenario that would lead to US$8 billion in losses by the global industry. But conversely, many major investment firms such as Goldman Sachs and SAC Capital are betting that the US housing market has hit a bottom and will begin rising again in the second half of 2012. Housing has powered almost every major US economic recovery since the 1950s, and such a boost could be the impetus for a restart in American economic growth. Thus it is possible that North American carriers will beat IATA’s estimated profits of US$1.7 billion in 2012, especially if the Eurozone is able to “muddle through” with only economic stagnation and avert a renewed recession, as well as a housing recovery is materialised or the US economy continues to strengthen.

In conclusion, new DOT rules will force significant changes in passenger advertising and affect traditional revenue streams, while the ETS is likely to have a minimal impact on US carriers in its first year of operation. Therefore the US airline industry is very likely to continue its trend of profitability in 2012, perhaps at the expense of the consumer as domestic airfares continue to rise.

After more than a year since Chilean carrier LAN Airlines SA and Brazil’s TAM SA announced its US$3.2 billion merger in August 2010 that, according to Bloomberg data, will create the largest Latin American airline as well as the world’s second-largest airline by market capitalisation at US$11 billion, after Air China whose market value stands at US$11.3 billion, the airlines are close to completing the deal which is expected to take place by the end of the first quarter of 2012 with LAN’s shareholders approval now being secured.

The combined airline will carry 59 million passengers and have a revenue of US$13.2 billion a year on a pro-forma basis with around 300 airplanes at the commencement of the airlines’ operation under the merged LATAM umbrella, which LAN’s president Jorge Awad said “will quickly grow to over 500 planes considering planes already ordered”.

“We are setting the foundations for an airline that will definitely have a major presence in the world’s skies. We will attend more than 60 million passengers per year, reach 26 countries and have more than 100 destinations,” Awad conceded.

The deal is expected to yield some US$400 million in annual synergies, with US$$170 million and US$110 million in synergies coming from its passenger and cargo businesses, respectively, in addition to a US$120 million cost synergy, the Chilean flag carrier said.

Image Courtesy of Boeing

The carriers won the regulatory approval from Brazilian anti-trust regulatory authority CADE on 14th December, which placed few conditions on the merger, requiring LATAM, as the merged carrier will be known, to divest 2 slot pairs at Sao Paulo’s Guarulhos Airport to be used on the Santiago-Sau Paulo route. The regulator, the last regulatory hurdle for the merger, saw no need for further slot divestitures for new services to other hubs of Chile’s LAN such as Lima and Buenos Aires, both of which see competing services from other carriers. Furthermore, LATAM, under which both LAN and TAM will retain their separate brands, is required to opt for one of the two global alliances which they are currently in, choosing between the oneworld alliance of which LAN is a founding member or TAM’s Star Alliance.

In comparison, Chile’s anti-trust regulator TLDC, which approved the merger back in September, placed 11 different conditions on the merger, requesting the divestiture of 4 slot pairs in Sao Paulo, and also requiring the selection of one alliance. Moreover, TLDC also asked for restrictions on LATAM’s service from Santiago to other hubs of the combined group such as Lima and Buenos Aires, as well as limitations on LATAM’s ability to enter into code-share agreements with non-alliance partners and the preclusion of LATAM from protesting certain decisions by the Directorate General of Civil Aviation of Chile regarding its air travel liberalisation. In addition, LATAM would have to join a different alliance than the one which Colombian carrier Avianca is in, which is halfway through the 18-month joining process of Star Alliance. As a result, LATAM is appealing three of the aforementioned conditions regarding code-shares, access to Lima, and the right of government to observe the operations at LATAM offices and data centres with a ruling expected in January 2012.

Regardless of the measures needed in addressing and allaying regulators’ concerns on the merger, its completion is undoubtedly a good news for these carriers that have had to wait more than a year since announcing the combination in August 2010. There are a myriad of additional filings, such as those with the United States Securities and Exchange Commission (SEC) that LATAM must still complete and final approval must still be obtained from the shareholders of Brazil’s TAM. Though the process has become much easier with the CADE and TLDC approvals, and the merger looks set to be completed by LATAM’s target of end of the first quarter of 2012.

LATAM will be a regional powerhouse with more significant synergies
Upon combination, LATAM will control more than 40% of the South American market, with significant market shares in Chile, Peru and Ecuador. LATAM will also be the single largest carrier in Brazil and Paraguay, as well as the second-largest in Colombia and Argentina. Simply put, LATAM will enjoy significant market shares of the air travel markets of 7 of the 10 largest countries in South America.

As aforementioned, the creation of LATAM will bring a US$400 million annual synergy with US$280 million in additional revenue generation, as well as US$120 million in cost savings, mostly through the elimination of redundancies in staffing and maintenance. However, Aspire Aviation thinks that both of these figures are conservative. For instance, the US$110 million additional cargo revenue does not take into account significant new cargo opportunities in Colombia as a result of LAN’s acquisition of Colombian domestic carrier Aires in October of 2010, which has since been renamed as LAN Colombia and integrated into LAN Group. LAN is already a major player in the Brazilian cargo market with its subsidiaries ABSA Airlines and LAN Cargo operating a joint hub at Viracopos-Campinas International Airport near Sao Paulo with ABSA operating another cargo hub at Sao Paulo Guarulhos. Moreover, the addition of TAM’s market recognition and the economies of scale resulting from combinations of the two companies’ cargo operations are going to boost the cargo revenue synergy further. In addition, as Brazil is one of the fastest-growing economies in the world yet the vast majority of its products are still transported via trucks and trains through Brazil’s inefficient ground infrastructure, the new LATAM could very well take advantage of its built-in structural efficiency to tap into any increase in the amount of domestic Brazilian cargo.

Similarly, the US$170 million figure in passenger revenue synergy does not take into account new opportunities that LAN Colombia brings. Business ties between Colombia and Brazil are increasing exponentially, with Colombia being the second fastest-growing market in South America after Brazil. Air links between the two countries are not well-developed and there are significant opportunities that lie in connecting them. Also in Colombia, LAN plans to utilise Bogota as a connecting hub for Central American flights. Whereas Aires might not have been able to sustain connections to the rest of South America, the combined market power of LATAM will ensure that Bogota becomes a viable hub connecting Central America to South America. Over the long term, it is possible for LATAM to develop Bogota into a North-South scissors hub akin to the Copa Airlines operation in Panama City.

Beyond Colombia, the largest sources of revenue growth will likely be “connecting the dots” within the LATAM network, and streamlining its long-haul connections. The idea of connecting the dots is especially prevalent in Rio de Janeiro, the fifth largest hub in the group. There, LATAM lacks service to its other hubs such as Lima, Quito, Guayaquil, and Bogota. Such opportunities exist in other large Brazilian cities like Brasilia, Salvador, and Porto Alegre, and even the secondary cities in LAN’s home countries such as Cuzco, Peru and Colombia’s myriad of large metropolises.

On cost synergy, LATAM failed to account for the incremental gains in cost reductions in Colombia where LAN Colombia employees are likely to handle the majority of its operations. Also, LATAM overlooked at the benefits brought by economies of scale regarding supply contracts. Typically, a larger order placed with suppliers entitles it to receive significant discounts that will result in lower unit costs for that good and with LATAM more than doubling the size of each carrier, contracts with caterers, parts suppliers can be renegotiated on more favourable terms when renewals are being discussed, with future contracts such as new aircraft orders with the original equipment manufacturers (OEMs) accruing a similar benefit. While the effect on individual small contracts may seem to be insignificant, the cumulative effect of savings can total millions of dollars.

Thus, Aspire Aviation estimates that the actual annual synergies resulting from the LATAM pairing will be closer to US$600 million as opposed to the US$400 million touted by the company, as the company has stated that the concessions demanded by TLDC and CADE will not cost more than US$10 million annually.

Image Courtesy of Airbus

Disparate long-haul strategies rationalised
Over the past few years, LAN and TAM have followed very different strategies for their respective long-haul operations. Whereas LAN has developed its operations through multiple hubs, TAM has focused mostly on building its operations out of Sao Paulo with a secondary operation in Rio de Janeiro. This is particularly evident in their respective destination portfolios. Whereas TAM has built strong operations in multiple intercontinental markets, close to 40% of LAN’s intercontinental capacity is focused in just two destinations, Miami and Madrid, which are the biggest ethnic destinations from South America. Meanwhile, TAM has actually ceded a large part of the Brazilian ethnic travel to TAP Portugal, electing instead to focus on serving business destinations from Rio de Janeiro and Sao Paulo.

Besides its large focus on Miami and Madrid, however, LAN’s long-haul offering does include many other destinations and LAN has arguably done a good job of structuring their network to optimise traffic flows. All of the carrier’s hubs have flights to Miami and most of them have flights to Madrid as well, with the rest of the network being optimised very well. For example, Lima, which is further north of its other major long-haul hub in Santiago, handles the majority of flights to Central and North America, whereas Santiago serves destinations in the South Pacific. Adding Sao Paulo to the mix would allow LATAM to align its hubs, with Lima serving North America to South America traffic, Santiago playing its current role, and Sao Paulo serving as the gateway to Europe and potentially Africa going forward.

Long-haul fleet strategies of these two carriers are both aligned to fit the goal of optimising their traffic flows. LAN has opted to move forward with a mix of Boeing 767-300ERs (Extended Range) and Boeing 787-8 Dreamliner with 32 of the carbon composite airliner on order to fuel its long-haul growth, of which 10 Boeing 767s and 12 Boeing 787-8s are going to be delivered over the next 4 years. Meanwhile, TAM has opted for a split fleet, with orders for 10 Boeing 777-300ER, 3 Airbus A330-200s, and 27 Airbus A350-900s, of which 10 examples will be delivered over the next 5 years that is slightly offset by the retirement of 3 Boeing 767-300ERs.

Short-haul fleets are remarkably homogenous for both airlines with the backbones being Airbus A320 family aircraft. LAN has placed a firm order for 20 Airbus A320neos (new engine options), whereas TAM still has outstanding orders for large numbers of current-generation Airbus A320 family aircraft, along with a firm order for 22 A320neos. However, given the competitive pressures of the Brazilian market, LATAM could swap several A320neo deliveries to TAM in order to reduce operating costs and ensure profitability in a market that features constantly eroding yields.

Combined carrier all but certain to select Oneworld
The TLDC’s conditions on the approval of the merger make it highly likely that LATAM will elect to join the oneworld alliance. As Avianca is more than halfway through the entry process of Star Alliance, the alliance simply will not turn a valuable future member down for the possibility that LATAM could elect to join it. Between SkyTeam and oneworld, the latter easily wins, which also applies to the competition between oneworld and Star Alliance, albeit to a lesser extent, given the close relationship between LAN and oneworld members American Airlines (AA) and International Airlines Group (IAG) subsidiaries British Airways (BA) and Spanish carrier Iberia. These oneworld partners have hubs at the two most important intercontinental destinations for LAN, American at Miami and Iberia at Madrid. The onward connections through these hubs represent highly important and highly lucrative revenue streams for LATAM, and switching to other alliances would limit such connections since other alliances’ hubs such as Houston and Frankfurt for Star Alliance would not be able to support as many non-stop flights to South America as oneworld would.

TAM’s switch from Star to oneworld would completely alter the alliance dynamics in South America. oneworld would control more than 50% of the long-haul travel market in South America, a figure that would easily rise to around 70% if International Airlines Group (IAG) manages to acquire Portuguese flag carrier TAP Portugal, which the Portuguese government is eyeing a privatisation to help beef up its national finance. Most importantly, with the execption of Avianca-TACA, Aeromexico, and Copa, oneworld would have within its ranks the most important South American carriers in LATAM. SkyTeam could potentially be marginalised as a result, forcing to utilise a poorly managed Aerolineas Argentinas and Brazilian low-cost carrier (LCC) Gol, which is not a member of any of the the three major global alliances, as its connections to the region.

Conclusion
The new LATAM will unquestionably dominate the Latin American airline industry, following the trend of market concentration established in other markets around the globe. Moving forward, its operating margin should hover in the 10%-12% range assuming full accrual of merger synergies by 2013. And the combined carrier’s market share will be large, controlling 50% of the regional South American market and more than 40% of the South American long-haul market.

However, despite LATAM’s dominance from a regional perspective, its positions within each market are not necessarily monopolistic. Each LAN Group subsidiary faces at least one domestic competitor – TACA Peru in Peru, AeroGal in Ecuador, Sky Airline in Chile, Avianca in Colombia which is in fact much larger than LAN Colombia, and Aerolineas Argentinas which is also larger than LAN Argentina. In each case, these competitors are either undercapitalised or mismanaged, such as Aerolineas Argentinas which was renationalised in 2008 in order to keep Argentina’s flag carrier afloat. Nevertheless these carriers still represent a significant competition to LATAM, and therefore LAN’s position in those countries cannot be considered as anti-competitive.

Furthermore, LATAM is not a monopoly and it even does not hold 45% of the market in Brazil. Domestically, there are a host of strong, fast-growing low-cost competitors such as Gol, Azul, and Webjet, which hold the largest combined share of the Brazilian market. On the international side, the LATAM combination does increase TAM’s share, but the overall pairing still holds just 31.1% of the Brazilian market. Overall, LATAM’s individual country operations do not come close to having monopolistic positions, and as such, there is no basis for a rejection of the merger on the grounds of competition concerns.

In conclusion, with LAN’s shareholders approving the merger in creating the world’s second-largest airline by market capitalisation, surpassing the current second most valuable airline in the world, Singapore Airlines, when LAN and TAM consummate their merger in the first quarter of 2012, the new LATAM will boost the profitability of the combined airline group while posing a lesser threat to consumer benefits with no significant reduction in market competition, which is beneficial to the South American airline industry.

In filing a Chapter 11 bankruptcy, Dallas, Fort Worth-based AMR Corporation, parent of US’s third-largest carrier American Airlines (AA) and its regional subsidiary American Eagle joined its peers in which every major US network carrier has gone through the bankruptcy process at least once in the past two decades in a drive to become competitive and solidly profitable by slashing costs and restructuring debt. As the US majors emerged from bankruptcies and became leaner and more efficient than before, American Airlines (AA) has arguably been left behind, struggling with the industry’s highest labour cost and a nothing but obsolete domestic fleet that is gas-guzzling which hurts the oneworld alliance member’s bottom line significantly. However, labour cost is hardly the only factor driving American Airlines into bankruptcy.

AMR Corporation and some of its subsidiaries, including American Airlines (AA) and American Eagle, filed for Chapter 11 reorganisation in the US bankruptcy court for the Southern District of New York on 29th November. During this process, the company is expected to continue its normal operations and maintain its frequent flier programme AAdvantage and the Admirals Club lounges. In addition, the company says it will continue to pay employee salaries, honour all fuel and other supply contracts, as well as interline and codeshare agreements with its partners. Alongside the announcement of the carrier’s bankruptcy filing, Gerard Arpey stepped down as American’s chairman and chief executive, who is replaced by Thomas Horton, American Airlines (AA) and AMR Corporation’s president since July 2010.

Importantly, the vast majority of American Airlines’ domestic competitors have undergone the Chapter 11 bankruptcy process at some point over the past two decades, which allows an airline to restructure its debts, renegotiate supply contracts and achieve lower labour costs. US majors such as United Airlines, Continental, Northwest, Delta, US Airways and America West all emerged from their respective bankruptcies with considerably lower debt loads, more favourable labour contracts and nimbler fleets. American was nearly in Chapter 11 bankruptcy in the wake of the September 11th attacks and the economic downturn that ensued, only to have averted it with a last-minute concessionary deal with American’s labour unions. However, this concessionary deal ultimately proved to be insufficient to overcome the more favourable labour contracts secured by its competitors. Since then American has trailed the industry’s financial performance for an extended period of time, suffering from losses in 10 of the past 11 quarters, as opposed to an overall profit for the rest of the industry during the same period. In fact, American Airlines has lost more than US$12 billion since 2001, a strong testament to the airline’s underperformance in finances.

American Airlines’ new chief executive Thomas Horton attributed this competitive disadvantage as one of the many factors behind the bankruptcy filing, stating: “We have met our challenges head-on, taking all possible action to secure our long-term position. In recent years, even as the airline industry faced unprecedented challenges, American strengthened our domestic and global network; fortified our alliances with the best partners around the world; launched a transformational fleet deal that will give American the youngest and most efficient fleet in the industry; and invested in our product, service and technology to build a world-class customer experience. But as we have made clear with increasing urgency in recent weeks, we must address our cost structure, including labour costs, to enable us to capitalise on these foundational strengths and secure our future. Our very substantial cost disadvantage compared to our larger competitors, all of which restructured their costs and debt through Chapter 11, has become increasingly untenable given the accelerating impact of global economic uncertainty and resulting revenue instability, volatile and rising fuel prices, and intensifying competitive challenges.”

The consensus amongst airline analysts is that American’s bankruptcy will not last longer than two years, and despite Chicago-based United Airlines had a four-year bankruptcy earlier this decade, Chapter 11 laws in the US have changed such that the majority of the restructuring must be finished within 15 to 20 months. The carrier plans to use mostly internal funds during the restructuring, thereby minimising any third-party funding and hence external influences during the process as well. American holds close to US $4.3 billion in cash and short-term liquid assets, which should be sufficient to keep it operating throughout the bankruptcy process, especially if it were to enact significant cost cuts during the period.

Image Courtesy of benh57

American driven into bankruptcy by debt loads, operating costs
While multiple factors combined drive American Airlines (AA) into bankruptcy, the two most important ones are its unsustainably high debt load, and its inflated cost structure relative to its peers. At the end of the 2011 third-quarter, AMR Corporation held roughly US$16.9 billion dollars of debt and US$12.6 billion net cash on hand. Much of American’s debt is related to long-term capital lease obligations on its aircraft, as well as its fleet of owned aircraft. Interest payments plus loan amortisation and depreciation cost AMR Corporation US$484 million in the third-quarter alone with direct lease payments costing a further US$165 million versus operating revenues of US$6.4 billion.

A Chapter 11 bankruptcy offers American a unique chance to significantly restructure all of its debt and renegotiate many of its supply contracts such as catering as well as aircraft lease agreements. While the supply contracts are not a huge source of concern for American, the nation’s third-largest carrier can easily reap the benefits from the incremental cost cuts with changes in its supply contracts. In terms of aircraft lease rentals, American had 225 aircraft under operating lease at the end of 2010, with close to 50% of them being the gas-guzzling McDonnell Douglas MD-80 aircraft, which burns 35% more fuel than a Boeing 737-800 NG (Next-Generation) does on a seat-mile basis. In AMR’s 2011 third-quarter results, its aircraft leasing costs are in line with industry averages, but as with the supply contracts, it can squeeze out some incremental gains in this particular area as well. The more lucrative opportunity lies in reduced capital lease costs and their related debt, as well as in rejecting some of the longer-term capital leases.

Earlier this decade, AMR Corporation chief executive Gerard Arpey was quoted as saying that American Airlines does not have a revenue problem, but a cost problem. While Arpey may have been engaging in a bit of hyperbole, the fact remains that American’s troubles can be directly traced to its inflated operating costs, which are significantly higher than those of its peers. For example, in the third-quarter of this year, American’s cost per available seat mile (CASM) for mainline operations was 13.85 cents, against the 13.13 cents at Delta Air Lines, 13.05 cents at United Airlines, and 12.93 cents at US Airways. Aspire Aviation has tabulated the relative operating costs of these three carriers’ consolidated operations including regional partners for the quarter, as well as a few other key metrics.

The table above neatly illustrates American’s troubles and would do so more impressively if fuel figures were broken down into mainline and regional operations. More than 95% of AMR’s fuel costs were attributed to its mainline operation representing around 92% of AMR’s capacity during the quarter. Nevertheless it is interesting to note that AMR’s fuel burn per available seat mile (ASM) figures are roughly in line with the industry average, which are only slightly worse. This makes sense given the large fleets of older fuel-inefficient aircraft operated by both Delta Air Lines with its ageing MD-80s, DC-9s, 767s and 757s and United Airlines’ 737 Classics, 757s and 767s.

American Airlines (AA) did however, address its uncompetitive position in both fuel and maintenance costs going forward with its gargantuan firm orders for more than 300 Airbus and Boeing narrowbody aircraft that was announced in July of this year, albeit at slightly increasing aircraft rentals. The combination of 100 Boeing 737-800s, 130 Airbus A320 family aircraft and 130 re-engined Airbus A320neo (new engine option) in addition to 100 re-engined Boeing 737 MAX as replacements for American’s 757-200s and MD-80s should reduce its fuel expenses by 20%-25%, and by 15-20% net of increases in aircraft rental and finance charges, Aspire Aviation estimates. When fuel efficiency improvements, coupled with the expected 30%-plus reduction in American’s maintenance costs during the early years of operations of these new efficient jets, American’s operating cost profile will likely be 6-7% lower than where it is today by 2018.

American’s labour costs inflated by benefits in compensation packages & poor productivity
However, it is undeniable that American Airlines (AA) has an inflated labour costs structure when compared to other carriers in the industry. As the chart above shows, American has the highest labour costs amongst legacy carriers by a significant margin of more than 25%, and this is the biggest contributing factor to the airline’s overall higher unit costs. Notwithstanding this, it is noteworthy that American’s direct wage rates are actually not the biggest source of disparity, rather, the significantly lower productivity of AMR’s employees and the industry-leading benefits contained in those employees’ compensation packages. For example, the average wages for AMR pilots in 2010 were just 0.9% higher than the average wage of pilots at every other US airlines. Flight attendants’ and ground workers’ salaries were 14.6% and 5.3% more than the industry average in the same period, respectively, while the average salaries of AMR’s in-house maintenance personnel actually beat industry averages by 4.9% in the same period of time. Simply put, American’s disadvantage in direct labour cost is just 0.7%.

American’s true labour issue lies in poor productivity. In today’s modern economy, the productivity of employees is considered to be a key metric by which to judge a company’s financial performance. And American Airlines is a dismal failure in this regard. For each dollar of compensation paid by American in 2010, its employees produced just 23.59 units of available seat miles (ASMs) versus an average of 29.06 units for its peers, and 28.50 units for the US airline industry as a whole. Such poor productivity is directly related to the work rules governing American’s employees. To zero in on the pilots, for whom the most information has been made public, several work rules negotiated by the Allied Pilots Association (APA) in the union’s last contract with the US’s third-largest carrier have become significant drags on American’s bottom line. For instance, APA pilots have shorter monthly maximum flight times than pilots at other carriers, and their ability to mix and match flight hours within their own ranks is severely limited. A significant number of American pilots are currently on reserve which comprise of more than 20% of AA pilots, during which they are mostly called for duty as replacements for pilots who cannot fly for whatever reason, rather than flying under normal schedules. During the past decade, American Airlines was prevented from expanding its long-haul flying into the booming Asian market because of a clause contained in its pilot contract which stated that the pilots had to approve any flights with flying times over a certain threshold. While reserve pilots are a necessity for any functioning airline, the pilots who were angered by bonuses given to AMR executives, used this clause to make a retaliation at the company, preventing it from launching new flights such as Dallas-Shanghai and Chicago-Hong Kong, as well as delaying the start of flights such as Chicago-Delhi. Furthermore, the carrier’s order for 42 Boeing 787-9 Dreamliner aircraft has not yet been firmed up due to contractual negotiations with pilots, subjecting American Airlines’ future network plans to a great deal of uncertainty, despite the fact that American’s 787-9 order may well be firmed up during the bankruptcy process. Overall, American’s litany of restrictive work rules are a significant factor in its overall labour cost disadvantage.

From a compensation perspective, American Airlines is literally the only US carrier to still offer defined benefit pension plans to its employees, as its competitors have all either frozen their defined compensation plan contributions, or terminated such plans altogether in favour of the 401k plans given to most employees at corporations in other industries. Under a defined compensation package, when an employee retires, he is paid a monthly lump-sum, regardless of whether or not the employee placed any money into his pension fund. With increasing life expectancy, coupled with a growing number of retired American Airlines pilots, defined compensation packages are becoming increasingly pricey. Indeed, AMR Corporation has paid out more than US$2.1 billion in pension contributions each year since 2002 while making an annual net profit just twice during that period. The table below illustrates the changes in pension plans at US carriers since 2002, and the reason for American’s inflated pension costs.

American’s generous compensation packages are not limited to its pensions. The carrier paid US$580 million worth of healthcare costs for its employees in 2010, more than any other legacy carrier. As a result, an American pilot received US$56,932 in pension payments and benefits a year on average, whereas other AMR employees received an average of US$21,946 a year. Both of these figures exceed industry averages by more than 20%, and represent the chief component of AMR’s quoted US$800 million annual labour cost disadvantage. Overall, AMR’s labour costs represent the single biggest laggard in its cost structure.

Revenues a catalyst to AMR’s bankruptcy
While American Airlines’ operating costs may be the underlying factor behind the AMR Corporation and American Airlines’ bankruptcy filings, the carrier’s changing revenue profile served as a catalyst in AA’s path to bankruptcy. As aforementioned, American Airlines did not consider itself to have been suffering from a “revenue problem”, but a “cost problem” instead. And for many years that was true – despite its operational challenges, AMR beat the average passenger revenue per available seat mile (PRASM) figure for legacy carriers in every year between 2002 and 2010, consistently achieving the second or third-highest PRASM amongst these US airlines. Thus AMR Corporation stated earlier this decade that its competitive response in light of the US airline industry’s intensifying competition was to wait for its competitors’ costs to increase naturally as a result of mergers between Northwest and Delta Air Lines, as well as the merger between United Airlines and Continental Airlines that formed the world’s largest carrier, rather than going down the bankruptcy path.

What changed American’s situation is revenues. While American Airlines was once the US market leader in revenue generation, the past two to three quarters ultimately proved to be a paradigm shift with its competitors gaining significant ground in this regard following the stronger networks created as a result of industry mergers. As the table above shows, AMR has seen its once superb revenue performance shrivels with the carrier now achieving just the fourth-highest consolidated passenger revenue per available seat mile (PRASM) of US legacy carriers. Although American Airlines’s PRASM had not been surpassed by United Airlines and Delta Air Lines since the late 1990s, American Airlines’ PRASM trailed Delta’s and United’s figures by 5.6 and 5.8% in the 2011 third-quarter, respectively.

Furthermore, even though the Dallas, Fort Worth-based carrier grew its unit revenues by more than 20% year over year in the third-quarter of this year, that still trailed the industry average by more than 10 percentage points. While there are numerous factors that have contributed to American’s decline in PRASM performance, the problems can be boiled down to 2 factors – its cornerstone strategy and its recent battles with the global distribution systems (GDS) such as Sabre Holdings and Orbitz Worldwide, Inc.

In September 2009, American Airlines (AA) announced a new company strategy that called for the carrier to eliminate superfluous point-to-point flying and refocus its efforts in Miami, New York, Los Angeles, Chicago, and Dallas Fort Worth, the five “cornerstones” of its route network. Launched in the midst of the most recent global financial crisis, this plan would allow American to streamline its operations to trim cost, and deploy its resources in the highest-yielding markets so as to better counteract its rising operating costs. It made sense for American to do so at the time and it was ultimately the correct decision: American needed stronger revenues to ensure its future viability and competitiveness. American was very efficient in enacting this strategy; today, just over two years since the plan was announced, more than 95% of its capacity is concentrated at those five hubs. Nonetheless American’s cornerstone strategy has its drawbacks albeit being a correct decision at the time.

For example, New York is often considered to be the most competitive market for airlines in the United States, with Los Angeles running a close second. Both of these hubs have large and lucrative business travel markets with plenty corporate contracts. As a result, they also attracted more competition from low-cost carriers (LCCs) such as JetBlue and Southwest Airlines as these LCCs look to improve their yields. JetBlue and Southwest have a large presence in New York John F. Kennedy and Los Angeles, respectively, highlighting the fierce competition between carriers vying for corporate contracts in these markets. American Airlines (AA) is essentially the fourth leading carrier in the New York City area, behind its arch-rivals Delta and United. The carrier is the market share leader in just 14 of the 75 largest origin and destination (O&D) markets from the New York City area. With Delta Air Lines growing stronger in New York via its recent slot swap transaction with US Airways, American’s competitive position there looks increasingly tenuous in the foreseeable future.

In Los Angeles, meanwhile, American is the market share leader by the number of passengers carried, but yet again trails the O&D performance of its competitors, with United leading in more than 15 of the largest O&D markets compared to just 10 for American Airlines (AA). A recent capacity build-up by Delta has already put downward pressure on average fares in Los Angeles, to the detriment of American. Its two strongest hubs are in Dallas Fort Worth and Miami, where the carrier controls at least 70% of the market and has a stranglehold on business travel in the area.

However, the operation in Chicago O’ Hare, which was once considered one of American’s greatest strengths, has lost some of its lustre in the past few years, particularly after United’s 2010 merger with Continental Airlines that formed the world’s largest carrier. American’s relative position to United Airlines in Chicago has slipped, with American’s operation falling to around 60% of United Airlines’ total number of passengers carried. In particular, this year has brought acute pressures on American with low-cost carriers Spirit Airlines and Virgin America both announcing new services originating from Chicago O’ Hare, and Spirit’s focus on key business markets threatens to place further pressure on fares in Chicago in the foreseeable future.

Simply put, American’s cornerstone strategy exposed it to intensifying competition with both its legacy peers and low-cost carriers (LCCs), placing downward pressure on unit revenues. But all indications were that American would be able to withstand the additional competitive pressure and maintain its operations without bankruptcy until it, in Aspire Aviation‘s view, decided to take on the global distribution (GDS) systems. The United States market is somewhat unique globally, since it has largely eliminated the usage of travel agents when booking airline tickets with the majority of such purchases taking place online. However, high-yielding business travellers still book through corporate travel agencies, most of whom utilise the GDSs for their confirmed seats and variety of options. Though legacy carriers prefer not to use GDSs, as they require additional fees to operate, and refuse to display lucrative ancillary products for airlines. Thus in December 2010, American Airlines filed an anti-trust lawsuit challenging virtually the entire GDS distribution industry, hoping to eliminate these middlemen fees and encourage direct purchases through American. Following American’s actions, GDS providers Sabre and Travelport retaliated, pushing American’s flights down to the bottom of their availability screens and not showing all of its fare classes for flights, or even dropping American flights from their systems altogether. While American Airlines (AA) has not specifically cited GDS actions as a reason for its slipping revenues, one can surmise that such an effect was likely a factor in American’s deteriorating revenue profile. As with the additional competition brought on by the cornerstone strategy, American might have been able to withstand the negative effects of their GDS battle, which did actually have some merit. But when taking both of these initiatives at the same time, the negative revenue effects were simply too much to overcome.

Simply put, American shifted its network strategy to put an emphasis on high-yield business travellers, and then attacked the very source through which the majority of business travel is booked.

The deterioration in the revenue profile changed the equation for American. It could have afforded to wait for competitors’ costs to catch up so long as their operations were profitable to ensure that their debt load would not balloon to an unsustainable level. With diminished fares likely resulting in lower-than-expected operating margins going forward, American chose to file for bankruptcy now, a time when it has US$4.1 billion in cash and can safely fund its bankruptcy, as opposed to one or two years down the line when its liquidity would be in a far more precarious situation. An unsustainable cost profile may be the ultimate cause of American’s bankruptcy filing, but the timing was ultimately determined by its deteriorating revenue profile.

Future expectations
Aircraft orders & existing fleet
There has been intense speculation in the media over the status of American’s large aircraft orders with Boeing and Airbus in light of its bankruptcy filing. While many outlets have speculated that AMR could cancel, defer, or be forced to modify its purchase plan, the fact remains that it is unlikely to have any significant change in the status of these orders. When American negotiated the terms of these deals, both Boeing and Airbus were most likely aware of the risk of a bankruptcy filing by American and both original equipment manufacturers (OEMs) have every incentive to ensure that American survives to take delivery of these orders in full. Since a member of Boeing’s capital team has been named to AMR Corporation’s 9-member court restructuring team Aspire Aviation does not expect any changes in the status of AMR’s large aircraft orders. In fact, the dispute that is currently delaying the formal signing of the 787 order will likely be resolved by in-court arbitration, which will allow American to dictate terms to its various labour groups.

The question of American’s existing fleet is a bit more nuanced. During the last major economic boom in the 1990s, American committed to long-term capital and operating leases for aircraft types such as the Fokker 100 and Airbus A300-600R, which were uneconomical in the high fuel environment in the 2000s. Thus these aircraft were mostly parked earlier this decade, with 74 aircraft being parked at the end of 2010, including 10 Airbus A300-600Rs, 59 McDonnell Douglas MD-80s, 4 Fokker F100s, and 1 Boeing 737-800s; 37 of which were leased. These long-term capital leases are very likely to be rejected during the bankruptcy process, of which AMR has already rejected the leases on 20 MD-80s and 4 F100s, and the owned aircraft in storage will likely be sold, or scrapped for parts. In terms of aircraft that is in active operation, it is not necessarily clear what will be done with the various aircraft types in its fleet. American has already stated that it will be decommissioning 11 Boeing 757-200 aircraft in 2012.

But the more interesting question is what will American do with its ageing fleets of 767-200ER and MD-80 aircraft. Of the 141 MD-80s American Airlines has leased, just 40-50 will be coming off lease over the next 5 years. Therefore American is likely to either entirely reject, or renegotiate the leases into short-term deals, with the latter serving as a stop-gap measure until the deliveries of its new fleet of Airbus A320s and Boeing 737 NGs begin. Aspire Aviation thinks that American will reject the leases on 30-50 of their oldest MD-80s in order to minimise maintenance costs. American currently operates 15 Boeing 767-200ER aircraft, almost solely on New York-West Coast sectors. These aircraft suffer from the same deficiencies as the MD-80s: fuel inefficiency and high maintenance costs. With the 12 leased 767-200ERs not coming off lease until 2015, it is likely that American will simply reject these leases and retire the 3 owned aircraft as well. Thus Aspire Aviation predicts that American will withdraw 55-90 aircraft currently in its fleet during the bankruptcy period, including the previously announced 757-200s. However, since American has roughly 40 Boeing 737-800s due to be delivered over the anticipated bankruptcy period, therefore the predicted net change in American’s mainline fleet is a withdrawal of 15-50 aircraft.

Labour contracts & scope clauses
As aforementioned, labour represents the greatest opportunity for cost reductions by the airline during the bankruptcy process. As American’s wage rates for aircraft in its existing fleet are close to the industry average, the possibility for significant wage reductions is likely to be slim. All told, a 3-5 percent reduction in wage rates is the likely upper bound for American’s current contracts with unions.

The question of scope clauses, and by extension pay-scales for the smaller Airbus A319 aircraft is a more troubling one. It has become apparent in recent years that American’s restrictive scope clauses, which heavily restrict the carrier from entering into capacity purchase agreements (CPAs) that utilise jets with more than 50 seats, are a significant drag on profitability. Its full-service competitors all operate more than 100 aircraft of more than 50 seats including certain aircraft with seat capacities as high as 90-seat, whereas American is restricted to operating just 47 Bombardier CRJ-700s configured with 63-65 seats. 70-seat regional jets are preferred by airlines as they blend the superior operating economics of larger types with the revenue maximisation of 50-seat regional jets. As American will likely be able to claim that its restrictive scope clause hinders its business viability, Aspire Aviation expects the bankruptcy court to approve up to 100 aircraft worth of 70-seat flying.

Meanwhile, it is noteworthy that American Airlines actually proposed a very restrictive scope clause in its most recent contract offer to the Allied Pilots Association (APA), one that called for all flying of more than 50 seats to be done by APA members, in return for expanded codeshare agreements and agreeable wage rates on smaller aircraft. With AMR Corporation’s 9-member bankruptcy team including 3 union members, it is likely that the court will allow American to both expand its codeshare agreements and create viable pay-scales for smaller mainline aircraft, perhaps as small as 100 seats.

From a pension perspective, Aspire Aviation expects that the bankruptcy court will allow American to emulate its peers and either freeze or entirely disband its defined benefit pension programme for employees, with such programmes being replaced with 401k-styled employee-led plans. Other benefits are expected to be curtailed, but items such as healthcare will likely remain in any future contracts.

Work rules are expected to be the most significant factor in savings for American, as the bankruptcy court is likely to allow the airline to dictate work rule terms to its employees. Aspire Aviation therefore expects that American will achieve the majority of its work rule goals through the bankruptcy court, with employee productivity being improved by up to 15%.

Debt restructuring
As Chapter 11 allows American to restructure its debt with a certain amount being reduced by the rejection of capital leases, it is likely that it will also be able to renegotiate the terms of lending on much of its existing debt, which could potentially reduce its interest expenses by 10% or more.

Network changes
While there are many outlets claiming that a bankruptcy protection allows American to cut unprofitable flying, Aspire Aviation thinks American does not need a Chapter 11 bankruptcy filing to cut unprofitable flying, which can be done within normal parameters of its business. In fact, much of the cornerstone strategy is built on the premise of eliminating superfluous and unprofitable flying, therefore Aspire Aviation predicts that American will enact capacity cuts of no more than 5% during its bankruptcy process.

Meanwhile, Aspire Aviation thinks the fear of Chicago O’ Hare being downgraded into a focus city is overblown, as the Chicago operation serves as a unique traffic flow in the American network providing transcontinental connections and gateway to the Midwest, and it is also an important business centre in which American cannot afford to lose corporate contracts. Therefore Aspire Aviation forecasts that Chicago O’hare will maintain its current hub status, with capacity cuts not exceeding 5-7%. Additionally, if American was able to garner significant scope concessions, and/or an economically viable agreement with pilots flying 100-seat jets, the Chicago hub might be strengthened. The Chicago hub was actually built up during a period when American had 100-seat jets such as the Fokker F100s and the addition of 70 and 100-seat jets to American’s fleet mix at O’ Hare would allow American to augment its existing service there and even cultivate in new markets.

Precedents of US airline bankruptcies
Aspire Aviation has reviewed Securities and Exchange Commission (SEC) filings for US airline bankruptcies during the 2000s, and created the following table comparing the change in cost per available seat mile (CASM) in the categories below. Changes were measured from the last full quarter prior to the airline’s bankruptcy to the first full quarter post-bankruptcy. We have listed all major categories of costs that can be affected by bankruptcy, with the exception of “other expenses” which includes many supplier contracts.

*Note US Airways merged with America West during the period, which may have skewed its data upward as America West had not recently entered Chapter 11 at the time of the bankruptcy.

As the table above illustrates, AMR’s competitors were able to enact significant cost reductions using a Chapter 11 bankruptcy process. Since the bankruptcy laws in the US have become more restrictive versus the earlier part of this decade, it is prudent to assume that AMR Corporation may only achieve 80% of the reductions that its industry peers secured.

Meanwhile, Aspire Aviation has compiled the hypothetical figures of AMR’s 2011 third-quarter financial results which American Airlines would have achieved had the cost reductions of a bankruptcy been realised during the quarter.

Conclusion
While a bankruptcy filing may present short-term hardships for AMR Corporation, American Airlines, American Eagle and its employees, it is the necessary move to ensure their long-term viability. American had been under severe strains owing to an oppressive cost structure and high debt load and filing a Chapter 11 bankruptcy is the appropriate step to bring it to parity with its full service competitors. While bankruptcies can always go wrong, indications are that AMR will emerge as a leaner and profitable carrier, one that is able to compete more vigorously in the cut-throat US market.

Image Courtesy of American Airlines

In releasing its 2011 third-quarter pre-tax profit of €1.1 billion, European plane-maker Airbus parent European Aeronautics, Defence & Space Co. NV (EADS) announced the Airbus A350-900 XWB’s entry into service (EIS) has been delayed by up to six months. The start of final assembly of the first A350-900 was deferred to the first half of 2012 and its first flight is now scheduled for early 2013 from the airframer’s previous targets of end-2011 and 2012, respectively. Entry into service (EIS) of the baseline variant in the mid-sized A350 XWB aircraft family, meanwhile, slipped to the first half of 2014 from late-2013.

Airbus’ head of the A350 programme Didier Evrard attributed the delay to the late arrival of the centre fuselage panels at its final assembly line in Toulouse, which are produced by Spirit AeroSystems in its Saint Nazaire, France factory.

“The centre fuselage panels will arrive by the end of the month, the spread between [the first arriving items] and this has been wider than planned,” Evrard said, further pointing out that the centre fuselage is the most complex part of the aircraft and therefore requires the longest lead time in the pre-final assembly process. “This is not only about suppliers,” he said, “but it is also about complexity”. Spirit AeroSystems is currently contracted to produce the A350’s front wing spars in addition to the centre fuselage panels.

Evrard also added that Airbus faced further issues with other suppliers, especially with tier 2 ones. While Airbus has put into place “joint improvement plans” with several of its tier 2 suppliers, there remain several issues with the readiness and detailed part manufacturing of these suppliers. “We needed to reach an acceptable level of travelled work,” he said. “We need to control this, otherwise we would not be able to control the lead time and efficiency”. Travelled work refers to out-of-sequence tasks that are not completed as originally planned, which Aspire Aviation’s sources at the European plane-maker have since downplayed these problems, claiming that the amount of out-of-sequence work is manageable, and the completion rate on most parts is “satisfactory”.

Airbus has already adjusted the project management of the aircraft programme in an effort to streamline the supply chain in December 2010, which also aimed to improve the organisational structure and decision-making process within the programme. This process, which was supposed to eliminate many of the supplier-related delays suffered by Airbus on its A380 as well as its transatlantic rival Boeing on its 787 Dreamliner, is understood to have failed to pay as many dividends that Airbus hoped for. Airbus currently outsources roughly 50% of the work on the A350, ostensibly to share financial risk.

During EADS’s 9-month earnings call, EADS chief financial officer (CFO) Hans Peter Ring stated Europe’s largest aerospace group has “seen some activities on the supply of key components being later than expected,” and that Airbus was facing a “shortage of parts” on the A350. Ring attributed the delays to financial difficulties currently faced by key suppliers. “All suppliers are in big difficulties. It is difficult for medium-sized companies to get access to funding,” he said, adding concerns about Europe’s macroeconomic environment meant Airbus had to remain “very vigilant throughout the supply chain” in order to avoid further delays. Ring refused to single out any individual supplier, saying, “I would not pinpoint this to specific suppliers – the whole system is under pressure. Airbus has deployed teams to help suppliers where necessary”.

In illustrating EADS’s risk mitigation strategy on the A350, Ring mentioned the company’s acquisition of a majority stake in German A350 tubings supplier PFW Aerospace, which saved PFW from bankruptcy and a production line shutdown, thereby preventing related delays to the A350 production.

Image Courtesy of Airbus

Further delays likely as Airbus grapples with weight reduction, new technologies
Having been delayed by more than one year, the A350 is likely to face further delays, which Aspire Aviation believes will ultimately total 2 years from its original mid-2013 entry into service (EIS) target, if not more. A 16th November research note by New York-based Bernstein Research to its clients states that, “the A350 situation at Airbus looks increasingly challenging, particularly after Emirates elected to order delivery of 777s spread over 2015-20. Based on our airline discussions in Dubai, we believe that A350 delays could extend beyond the current schedule, with the need for substantial weight reduction”.

Aspire Aviation’s various sources at the European airframer have reiterated that while the A350-900 is modestly overweight in Airbus’ design software, design changes have enabled parts arriving in Toulouse’s final assembly line (FAL) to be only slightly overweight. However, slight weight problems on each individual part can easily add up to tonnes of overweight on an aircraft as large as the A350, which helps explain Bernstein’s statement. The research firm now expects the first delivery of the A350-900 to take place in mid-2015, more than a year later than Airbus’ current projection.

Even more important for the A350-900 is risk management, to which Airbus attributes a significant chunk of the A350’s 6-month delay. “The foundations of the programme are robust and a lot of risks have been mitigated, sometimes at the expense of more time spent – wing root joint, stringers damage tolerance, electrical systems installation – but always for the maturity of the programme,” EADS stated in June. Industry analyst Scott Hamilton of Leeham Co. stated that it is prudent for Airbus to build additional margins totalling as many as 6 months in the A350-900′s schedule, which Aspire Aviation concurs, given the unprecedented amount of new technologies featured on the Airbus A350.

The A350 has been called a “hybrid” project by Airbus comprising 52% lightweight carbon fibre materials, which are being found on its fuselage panels, joints, fasteners and keel beam, while maintaining the aluminum frame typical of current generation aircraft. Even though Boeing has already proven such technologies on the 787, composites manufacturing remains challenging, contributing to part of the significant delays to the 787 Dreamliner and potentially the A350 XWB.

Airbus has elected to use composites only on the A350′s wings. The new wing, which has a surface area of 443 square meters featuring a sweep angle of 31 degrees, enables the A350’s typical cruise speed to Mach 0.85. A new high-lift system has been adopted for the trailing edge of the wing, utilising an advanced dropped-hingeflap, enabling the gap between the trailing edge and the flaps to be closed using the spoiler, in addition to the differential flap setting (DFS) and variable camber (VC) which redistribute critical loads inward and help reduce weight.

Airbus has also incorporated numerous technologies from its larger A380 superjumbo aircraft on the A350, including its nose configuration adopted from the A380 with a 6 panels cockpit glazing and a forward mounted nose landing gear bay. Additionally, the aircraft’s integrated modular avionics were first developed for the A380, although the A350’s examples manage up to 40 in-flight functions whereas the ones on the A380 only control 23.

However, perhaps the most relevant new technology is the all new Rolls-Royce Trent XWB engine currently under testing by the British engine maker. Rolls-Royce recently stated that a minor design change to the initial Trent XWB engine may push the first flight of the engine back by a few weeks. In September, the manufacturer completed the required 150 hours endurance test for the Trent XWB, as well as a bird strike test during which four 1.1 kg birds were ingested by the engine. During the endurance test, Rolls-Royce discovered damage on the “rotating air seal that separates the [intermediate pressure] turbine (IPT) from the back of the [low-pressure] turbine.” However, Chris Cholerton, Rolls-Royce’s director of the Trent XWB programme downplayed the issue, noting that RR has already manufactured an updated design. “We may elect to change that prior to flight, because we can, it is simple to do,” Cholerton said. “We can do it here in Toulouse. We can still be flying the testbed over a year ahead of first flight. We want to test the final production standard of part, that is a good thing to do for our maturity objectives.”

The first Rolls-Royce Trent XWB powerplant, which is rated at 84,000 lbs. of thrust, is considered as an evolution of both the Trent 1000, which is one of two engines powering the Boeing 787 Dreamliner, and the Trent 900 powering the Airbus A380. Given the engine issues on the modifications A and B of the Trent 900 on Rolls-powered A380s, as well as the 2%-4% specific fuel consumption (SFC) shortfall on the Trent 1000, it would be beneficial for Rolls-Royce to take more time to test the engine and ensure the SFC meet its original specifications at service entry (“Challenges remain as Boeing 787 becomes reality“, 3rd Oct, 11).

Rolls-Royce stated that the specific fuel consumption (SFC) tests for the Trent XWB were tracking ahead of expectations for early build engines, and that the company expects the Trent XWB will be the “world’s most efficient civil turbofan”.

While the majority of airline customers have remained relatively mute over the latest delays, chief executives at the rapidly growing Middle Eastern carriers have struck out at Airbus over them, primarily because the delays will limit their growth. Emirates chief executive Tim Clark told Aviation Week that “they [Airbus] told us this would never happen again and everything is under control”. Clark and other airline executives are especially concerned as Airbus has already announced a year’s worth of delays before final assembly of the A350 even starts, whereas the 787’s troubles began after rollout. At this November’s Dubai Air Show, Emirates announced an order for 50 Boeing 777-300ERs with 20 options, a move many industry analysts see as a hedge against further A350 delays.

Ironically, Emirates Airline chief executive Tim Clark’s statements almost seem moderate when compared to the acerbic remarks made by Qatar Airways chief executive Akbar Al-Baker. Al Baker used the negotiations over a separate Qatar Airways order for Airbus A320neos and A380s to voice his displeasure over the A350 delays. In a statement to the media before reaching a deal with Airbus and placing firm orders for 50 A320neos and 5 additional A380s, Al Baker said, “as far as Airbus is concerned, we have reached an impasse. We thought we would conclude our agreement and make a very large announcement today. Unfortunately I feel that Airbus is still learning how to make airplanes”.

A350-1000 faces own troubles
Clark and Al-Baker may have been particularly vituperative towards Airbus given their displeasure over the largest A350 variant in the aircraft family, the A350-1000. Speaking to media at the Dubai Air Show, Clark said regarding the A350-1000, “we want the original specification I do not remember that we wanted something new and I really wonder why they [Airbus] did not ask”.

Emirates and Qatar Airways feel that the redesigned A350-1000 launched by Airbus in June at the Paris Air Show in June with a two-year delay in entry into service (EIS) to 2017 is not the aircraft that they originally signed up for, and that the operating economics on these new aircraft may have been compromised by the increased weight, which has not fully been offset by the increases in range and maximum take-off weight (MTOW).

In June, Airbus announced a two-year delay to the A350-1000’s EIS to help facilitate numerous design changes to the largest A350 variant. As part of these modifications, the engine thrust on the modified Trent XWB powering the A350-1000 will be increased to 97,000 lbs. from 93,000 lbs. The additional thrust will enable the A350-1000 to carry 350 passengers fly 400 nautical miles (nm) farther, or another 4.5 tonnes of payload, prompting an increase in maximum take-off weight (MTOW) of the aircraft from 298 tonnes to 308 tonnes. The aircraft will retain the same fuselage size as before, as well as almost 100% hardware commonality with the A350-900, but the wing will be “optimised, not new,” implying that Airbus will utilise a scale-up of the A350-900’s wing with few modifications.

Airbus is optimistic that the more powerful Rolls-Royce Trent XWB engines on the A350-1000 will not affect the aircraft’s fuel burn performance, claiming there is “no specific fuel consumption impact”. The upgraded Trent XWB engine will feature the same 118-inch fan blades as the smaller XWB, but will spin 6% faster and feature altered internal aerodynamics and a 3-4% larger core with a scaled up annulus will draw a larger airflow through the same intake. Additional efficiency tools include a dual microstructure technique implemented in turbine manufacture that enables the properties of the engine discs to vary in line with the different temperatures at the engine’s hub as compared to the engine’s rim.

These engine modifications will add roughly 2.4 tonnes to the aircraft’s empty weight. Additionally, Aspire Aviation has learned from its sources at Airbus that the Airbus A350-1000 is around 5 tonnes overweight in Airbus’ design software. The combination of these two factors could represent a significant fuel burn penalty, which Aspire Aviation estimates at around 3%-5%, for the A350-1000. However, given that Airbus will have at least 5 years worth of time before the A350-1000’s revised entry into service (EIS), Aspire Aviation thinks Airbus should be able to implement weight reductions to recover a large portion of these added 7.5 tonnes.

In spite of all its troubles, the A350-1000 is nevertheless likely to be a highly efficient up-scale of the A350-900, with fuel burn per seat between 15%-25% better than the Boeing 777-300ER.

Though Qatar Airways and Emirates have been vociferous about the performance shortfalls, as the additional 15 seats and larger cargo space of the 777-300ER can outweigh the better fuel efficiency of the A350-1000 XWB, especially given the around US$ 25 million list price differential between the two aircraft.

Furthermore, Boeing is very likely to strengthen its market leadership in the 350-400 seats segment by launching a revamped 777-8/9X, a move already under consideration by the Chicago-based aircraft manufacturer. However, Boeing does have a buffer period and more leverage while deciding whether to go forward with the major 777 upgrade, as industry analysts mostly agree the A350-1000′s entry into service (EIS) could easily slip into 2018-2019, and possibly even early 2020. Aspire Aviation reported in December that Boeing is eyeing a provisional date of launch for the 777-8X/-9X in 2013 with a 2019 entry into service (EIS) with the -8X and -9X being the revamped versions of the ultra long-range 777-200LR and the popular 777-300ER variants, respectively.

A new 777X would likely feature a revamped version of the GE90-115B1 engine that currently powers the Boeing 777-300ER. Boeing is targeting a 10% specific fuel consumption (SFC) improvement for the new engine versus the already fuel-efficient GE90-115B1 which burns 0.25 pounds of fuel per pound of thrust delivered per hour (lb/lbt/hr), which would negate a large chunk of the fuel burn advantage currently possessed by the Rolls-Royce Trent XWB engines.

From a payload perspective, the A350-1000 currently has a maximum take-off weight (MTOW) of 308 tonnes whereas the 777-300ER has an MTOW of 351.55 tonnes. A 777-9X which is slated to replace the 777-300ER would likely see a modest MTOW reduction to around 342 tonnes while retaining a similar range to that of the 777-300ER primarily owing to the weight saving brought by the new composite wings. The 777-9X would also likely be scaled upwards to around 390 seats through “internal stretching” of the cabin.

When coupled with a 10% fuel burn reduction from the engines, the additional seats would push the fuel burn per seat reductions to 10-15% versus the 777-300ER (“New Boeing 777X likely to be a highly efficient derivative”, 14th Sep, 11). Additionally, increased usage of composites, and/or aluminum-lithium (Al-Li) technologies would provide both weight reductions and improved maintenance costs. That said, the cash operating costs (COC) of a 777-9X could easily be 20-25% less than the Boeing 777-300ER’s, which if Boeing were to maintain the 8.1% advantage in list prices for the 777-300ER versus the A350-1000, would in fact give the 777-9X an advantage in direct operating costs (DOC , DOC = COC + capital cost).

Aspire Aviation thinks that Alcoa’s 3rd-generation aluminium-lithium (Al-Li) technology, which the world’s largest aluminium producer says offers a 12% better fuel efficiency with 10% weight saving and a 6% reduction in skin friction drag, as a very attractive option for an application on the 777X, given the existing production system of aluminium materials is well understood and it carries substantially less risk as well as costing substantially less than upscaling the autoclaves composite production system adopted by the Boeing 787 Dreamliner programme.

Delays will not affect business case of A350-900
Despite the short-term troubles for the baseline A350-900 variant, much as with the 787, its longer-term prospects remain sound. Delays are always pricey for original equipment manufacturers (OEMs), and Airbus could still be forced to push the A350-900 further back.

However, the Airbus A350-900 occupies a unique niche as a replacement aircraft for current generation widebodies, it is probably the only true replacement for the Boeing 777-200ER, which is the second most popular 777 variant of which 428 examples have been sold through October 2011, only behind the 777-300ER’s stellar sales performance of which 545 examples have been sold by the end of October.

Whereas Boeing has pitched both the 787-9 and the potential 787-10X as 777-200ER replacements, the 787-9 is considerably smaller than an A350-900, and the 787-10X’s proposed payload/range capabilities are insufficient to truly replace the 777-200ER, which in fact serves well as an A330-300 replacement with a range of 6,800 nautical miles (nm) while offering a 20% fuel burn saving over an A330-300. Therefore carriers will likely be forced to choose between the 777-200ER and the A350-900 XWB for replacement and growth, absent a revamped 777X that is designed as a true 777-200ER replacement. A few carriers, such as Japan’s All Nippon Airways (ANA) have elected to remain operators of the Boeing 777-200ER with additional orders for a few more examples. But the vast majority of airlines have ordered the A350-900, and with good reason. As the economic analysis below shows, the Airbus A350-900 enjoys a significant advantage operationally versus the 777-200ER.

Aspire Aviation has performed an economic analysis on the Airbus A350-900 versus the Boeing 777-200ER on a route of 5,500 nautical miles, which is within the typical operating envelope of the Boeing 777-200ER, with zero wind speed. This analysis makes numerous assumptions, most of which are actually favourable to the 777-200ER, and thus illustrates the A350-900’s significant advantage over the Boeing 777-200ER. A full list of assumptions is listed below.

Based on these assumptions, the following relationships between the Airbus A350-900 and Boeing 777-200ER are presented on an operating cost basis. Figures are given on a per seat basis and configurations used are 234 seats (8/42/184) for the A350-900, and 250 seats (10/45/195) for the 777-200ER, which are equivalent in terms of passenger density per unit of floor area.

Fuel Burn
For this mission, the Airbus A350-900 is around 24% more fuel efficient than the 777-200ER, mainly because the A350’s advantage in fuel burn during cruise is lessened due to the shorter stage length. During climb and descent, the A350 burns a similar amount of fuel to the 777-200ER. On longer missions that is 6,000 nautical miles (nm) and beyond, the fuel burn saving will likely be closer to 25-28%, matching Airbus’ figures.

Maintenance
The A350 was assumed to have maintenance costs roughly 20% better than those of the Boeing 777-200ER, reflecting highly increased usage of composite and alloy technologies, as well as other maintenance reductions on the A350.

Navigation and Crew
The navigation and crew costs were estimated to be the same or similar as both the A350-900 XWB and the 777-200ER would be in any country such as India)where navigation fees at airports are measured by aircraft type, not specific weight. Given that the A350-900 would serve as a direct replacement for the 777-200ER, crew costs would likely be similar for both types.

Finance Charges
The Airbus A350-900 is priced at roughly US$22 million higher than the 777-200ER. Monthly lease rates for airlines with good credit are typically on the range of 0.8% of the aircraft’s purchase price, and both aircraft were assumed to have annual utilisation rates of 4,750 hours, which are in-line with the standard utilisation on medium to long-haul routes by world airlines. (Note: the 4,750 annual flight hours figure was used for the maintenance calculation as well). Discount for the aircraft was assumed to be 35%.

Overall
While the figure of 10.6% better operating costs per seat for the A350-900 seems low, that figure is between US $15,000 – US $20,000 for typical flights in this range, which is a significant amount. And at longer ranges, the low fuel burn of the A350-900 would make that differential even bigger. Finance charges are perhaps the greatest equaliser, depending on the discounts offered, the 777-200ER could potentially become cheaper on a direct operating cost (DOC) basis, though it would likely require discounts of closer to 70% in order to achieve this rather than a typical discount rate of 35% by Boeing assumed in this analysis.

Revenue Generation
From a revenue perspective, at identical passenger density configurations, the 777-200ER has two more first class seats, three more business class seats, and eleven more economy class seats. For typical 3-class 777-200ER flights in the US such as those operated by United Airlines and American Airlines (AA), one-way fares in these classes usually trend towards the ratio of 6:3:1. Thus the 777-200ER would have a maximum earning potential of 8.9% more passenger revenue, assuming static yields for the remaining 15 seats. At the typical 80% load factor for long-haul flights, that figure would be around 7.2%. On the cargo side, the A350-900 can carry 8.6% more cargo, which at typical belly load factor of 60%, would translate into a 5.2% revenue advantage from cargo for the A350-900. All in all, the 777-200ER would enjoy between a 6-8% maximum revenue advantage over the A350-900, or 4-7% at typical loads. This revenue advantage cannot outweigh the more than 10% operating cost advantage held by the A350-900.

Conclusion
As with the 787, the negative effects of A350 delays will eventually be outweighed by the superior operating economics offered by the aircraft. Airbus has been painstaking in its attempt to ensure that the A350-900, with all of its new technologies, is mature before it enters into service and it is unquestionably better to have any potential safety issues discovered and fixed before delivery than after the aircraft type entered operation. In the short to medium term, however, these delays will provide a moderate boost to the A350′s competitors such as the Boeing 777-300ER and 787-9 Dreamliner, similar to the boost seen in A330 sales precipitated by perennial delays to the 787. Notwithstanding this, the A350 should regain its edge over its competitors in the long-term, which is subject to change owing to Boeing’s potential response.

‪For the A350-1000, only time will tell what its true sales potential is. While the aircraft is likely to be a highly efficient stretched variant, a lot will depend on Boeing’s response to the A350-1000. In the interim, if Boeing were to introduce a further Performance Improvement Package (PIP) for the 777-300ER which will improve its fuel burn by 4% (“777 PIP further negates A350-1000′s business case“, 1st Mar, 10), which, combined with a 777-9X with a 2019 service entry, would likely squeeze A350-1000 sales. Though several carriers who have purchased the A350-800s and A350-900s have options to convert their orders to the larger A350-1000 variant, and any further design improvements may prove to be attractive to them.

‪All in all, the Airbus A350-900’s long-term prospects remain sound despite the latest 6-month delay in its entry into service (EIS) date. The A350 is an innovative product that builds on a leap in engine technologies to deliver superior fuel burn and maintenance improvements, both of which will ensure its place in airlines’ fleets for decades to come.

On 19^th October, 2011, Air New Zealand (ANZ) announced an order for 7 new ATR 72-600 aircraft plus five options for growth of its domestic regional operations. The airline stated that while it had given consideration to both Bombardier and ATR for this latest order, it had chosen the ATR aircraft due to its superior fuel burn performance and optimisation for operations in poor weather conditions. Air New Zealand’s regional operations are currently operated by a mix of 11 ATR 72-500 and 23 Bombardier Dash 8 Q300 aircraft amongst others. Yet despite this split fleet, Air New Zealand has chosen to utilise ATR’s aircraft for its future.

Air New Zealand’s choice of ATR as their regional partner hints at a broader trend across the regional airline industry. Over the course of 2011, ATR has beaten Bombardier on numerous head-to-head request for proposals (RFPs), winning 116 orders for its ATR 72 turboprop versus only 21 orders for Bombardier’s Q400. Within those 116 orders, 49 have been placed for the current generation ATR 72-500, while 67 orders have been placed for the next-generation ATR 72-600, which features a new cabin layout with larger overhead bins, improved seating and a cockpit including required navigation performance (RNP) technology, as well as improvements in fuel burn and maintenance costs over the ATR 72-500.

In fact, besides SpiceJet’s order for 15 Q400 aircraft which is reportedly considering converting its 15 commitments into firm orders, Bombardier has not won a significant order for its Q400 aircraft since Jazz, an Air Canada regional partner, ordered 15 examples in late 2010. However, despite the dearth of recent sales,Aspire Aviation does expect that Bombardier could win a significant number of orders for its turboprops over the next five years, especially if the carrier were to launch a re-engined Q400, dubbed the Q400X, or potentially a new 90-100 seat turboprop that has been tentatively called the Q700.

Image Courtesy of Bombardier

It is Aspire Aviation’s view that current fleets of regional jet aircraft, especially for feed of full-service hubs in the United States and potentially Europe, are likely to be partially replaced by regional turboprops, even in light of Embraer’s recent decision to re-engine its popular E-Series aircraft.

In the United States, a large portion of the hub operations of full-service carriers are currently operated by regional partners on a capacity purchase agreement (CPA) basis. More often than not, these CPA agreements involve the operation of 50-seat regional jets such as Embraer’s ERJ-145s or Bombardier’s CRJ-200s. At certain airlines, CPA agreements are also in place for 65+ seat aircraft such as Bombardier’s CRJ-700 or Embraer’s E-170 family.

However, recent competitive trends domestically and the natural increase in employee costs over time for legacy airlines, have led US legacies to increase pressure on their regional partners to provide cost savings on CPA flying. Yet the regional carriers are grappling with many of the same issues that plague the legacies, including almost as high employee costs on a seat-mile basis. Perhaps their best option to reduce operating costs and meet the demands of their legacy partners is to reduce fuel and maintenance costs. The current fleet of regional jets is ageing and fuel thirsty; thus replacing this fleet might be the most viable method of reducing regional operating costs. Simply replacing these regional jets with more regional jets would improve direct maintenance costs. However, such an action would not enact very significant fuel cost reductions. Bombardier and Embraer have both cancelled their 50-seat regional jet programmes entirely, and their 70-seat jet programmes are currently selling at depressed rates relative to the purchase boom seen in the earlier part of this decade. Given these constraints, replacing these aircraft with turboprops such as the Q400, and especially a next generation Q400X, could boost profitability and margins at struggling US regional carriers.

Turboprops, by their very nature have slower cruise speeds than comparable regional jet aircraft. However, due to their lower cruising altitude and resultant reduced ascent and descent times, turboprops are actually faster than jets on shorter routes. For example, it is Aspire Aviation’s understanding that the Q400, with its roughly 360 knots cruising speed currently operates at relative air time parity with much faster regional jets on segments of 450 miles or less. Thus we estimate that a re-engined Q400X with cruise speed of close to 400 knots would be able to match regional jets on a time basis over distances of up to 800 miles, and would not face much of a time penalty on routes of up to 1,000 miles. Aspire Aviation has compiled data from the US Department of Transportation (DOT) that shows that a large portion of current regional jet operations in the US fall into the aforementioned distance categories.

Source: US DOT Form 41 Traffic Data

Utilising turboprops to replace regional jets offers multiple advantages. Firstly, the fuel burn of the current generation turboprops is far better than that of regional jets, a distinction that would be only magnified by the introduction of a re-engined or next-generation turboprop. Such a turboprop as the US DOT Form 41 data indicates, would possess an operating cost advantage of 10%-25% versus regional jets, and a fuel burn advantage per block hour of close to 50%. Secondly, turboprops are able to serve smaller airports more efficiently. Over the past 4 years, US regional carriers have cut flights to numerous destinations, citing high operating costs for the regional jets primarily used to serve these routes. With more efficient turboprops in play, some of these airports might become viable spoke destinations yet again. Furthermore, the runway length required by turboprops carrying a full payload to take off is often less than that of fully-loaded regional jets. There are certain destinations, especially in mountain resorts such as Aspen and internationally such as those in the Caribbean that can only be served with 50+ seat turboprops, not regional jets.

The use of turboprops as feeder aircraft is not an entirely newfangled concept. For many years, US carriers operated smaller turboprop aircraft under “Express” or “Connection” branding for regional feed purposes. While the majority of these smaller turboprops have been retired, there remain a few major turboprop operations in the United States. American Eagle Airlines and Colgan Air operate ATR 72-200s and a variety of Bombardier Dash 8 including the Q400 aircraft, respectively. Numerous other carriers operate smaller versions of the Dash 8 as well. And perhaps most pertinent to a discussion of regional jet replacement is Horizon Air, regional partner of Alaska Airlines. Up until 2010, Horizon Air had operated a mixed fleet of Dash 8 Q400 and CRJ-700 aircraft providing feed to Alaska Airlines’ hubs in Seattle and Portland. However, in the face of mounting operational losses, the carrier decided in 2010 to convert its operation to solely operate turboprop Q400 equipment, stating that the fuel efficient Q400s were more economical feed aircraft than their own regional jets. Given that Horizon’s average stage length in the Western United States is longer than that of many regional carriers Eastern US, their conversion provides compelling evidence that Q400s can in fact function as effective feeders to modern hubs.

Perhaps the best indicator of the potential of turboprops to replace regional jets can be found in the actions of SkyWest Inc. SkyWest Inc, which is comprised of US regional carriers Atlantic Southeast Airlines (ASA) and ExpressJet which are now merged, as well as SkyWest Airlines, is the single largest CPA carrier in the United States, operating a fleet of 705 aircraft in partnership with United Airlines, Delta Air Lines, and Alaska Airlines. Currently, the carrier’s only turboprops are 48 thirty seats Embraer EMB-120 Brasilias, which are partially operated on behalf of United Airlines with a few being utilised on a stand-alone, at-risk basis. However, during SkyWest’s 2011 third-quarter financial results conference call, company executives stated that they had issued an RFP for fleet replacement during the previous calendar year, and that negotiations with various manufacturers were going “very well.” If SkyWest were to elect to order a certain number of turboprops as part of its overall fleet replacement, it would provide strong indication that replacement of regional jets is a new market for turboprops.

For reasons that will be outlined below, Aspire Aviation feels that the Bombardier Q400 and its future derivatives are more adequate replacements for regional jets than the ATR 72 or its future derivatives:

Operating cost
Aspire Aviation has used 2010 US Department of Transportation (DOT) financial reports to compile the following data on the operating costs of the turboprops, as well as the major 50 and 70 seats jets operated by US airlines.

Notes: All data is per seat per flight hour
Data mentioned above is solely for ATR 72-200; there are no US operators of the ATR 72-500 and -600
The Q400 was used as the benchmark to which the other aircraft are compared; all data is in relative terms
Seat counts used: 72 for ATR 72, 78 for Q400, 50 for CRJ-200 and ERJ-145, and 76 for CRJ-700 and E 170

On a head-to-head basis, the ATR is more fuel efficient per seat than the Q400 by about 15%, however its direct operating costs (DOC = cash operating cost (COC) + cost of capitals) are close to 25% higher, in large part due to maintenance costs. However, the ATR 72 fleet in the US is generally much older and composed of the -200 series aircraft, which could partially explain the large maintenance cost disparity. Still, these figures partially affirm an oft-rumored occurrence – the ATR 72, while being more fuel efficient, is not always cheaper to operate than the Q400s.

Moreover, the ATR 72 is not truly a viable replacement for regional jets in the United States, as its low speed even with a next-generation replacement limits its capability to effectively feed US regional jet hubs. Meanwhile a new Q400X aircraft could cruise at speeds close to 400 knots, allowing it to more effectively replace regional jets in the US, especially on routes of under 800 miles.

The data indicates that the Q400 easily holds a 10-20% operating cost margin over the current generation of regional jets, and a 50-80% fuel efficiency margin as well. This gives Bombardier significant leeway in developing the Q400X, as they can trade a certain amount of fuel efficiency to maximise the cruising speed.

The data referenced above is for the year 2010. In 2011, however, the fuel price has risen more than 30% year over year. For these 5 aircraft excluding ATR turboprops, fuel makes up somewhere between 40% and 50% of total operating costs. So under current fuel conditions, the Q400X becomes even more attractive as a replacement aircraft.

Image Courtesy of The Wings and Wheels

New turboprop technologies
Both Bombardier and ATR have indicated their interests in doing a next-generation turboprop. ATR appears to favour a 90-seat revamped version of their ATR 72-600 optimised for a lowest specific fuel consumption (SFC), while Bombardier is vacillating between a modified version of their Q400 NextGen dubbed the Q400X, or an all-new 70-100 seats turboprop.

On modern turboprops, by far the dominant engine is Pratt & Whitney Canada (P&WC)’s PW100 series, which is used on both the ATR 72 and the Q400 NextGen. The ATR 72 uses the PW127 series, which holds a maximum continuous rating of roughly 2,600 shaft horsepower (shp).The Q400 NextGen meanwhile uses the 5000 shp PW150 engines. But a next-generation turboprop would require new engines, especially if the capacity is scaled up to 90 seats.

General Electric (GE) is already in advanced talks with numerous airframers about a new turboprop engine. Tentatively dubbed the CPX38, GE’s new engine would be based on its GE38 engine, which is used on Sikorsky Aircraft’s CH53K helicopter ordered by the US Marine Corps., the first of which has already entered final assembly. The 3 GE38 engines on each CH53K are rated at 7,500 shp, but the proposed CPX38 would be in the 5,000 shp class. GE has not yet officially launched a CPX38 programme, but has indicated that it could quickly launch such a programme with an entry into service (EIS) in 2015-2016 timeframe due to the common core with the GE38. Targeting a 15% specific fuel consumption (SFC) improvement over the current-generation turboprop engines, the CPX38 is also expected to feature an integrated propulsion system of the propeller, engine, and nacelles. Integrated propulsion systems improve engine reliability and efficiency, and contribute to SFC reductions as well.

Pratt & Whitney Canada (P&WC)’s next-generation offering is also expected to utilise an integrated propulsion system. The engine maker is targeting a 20% reduction in engine fuel burn over the PW100/150 series engines that power both the ATR 72 and the Q400 NextGen. Part of the planned fuel burn reduction is expected to come from the use of technology first developed for Pratt’s geared turbofan engine for narrowbody jet aircraft.  P&WC has already tested the first components of its new engine this year, and expects to launch the product after conducting a full core test by the end of 2012. The new engine’s core will break its existing commonality with the PW100 series and as such the entry into service (EIS) is expected to be in 2016 or beyond. While GE has committed itself to a 5,000 shp class engine, P&WC has left the door open to an engine anywhere between 5,000-7,000 shp.

ATR has already stated its preference for a 90-seat next-generation turboprop. The EADS-Alenia joint venture is currently conducting studies for a new turboprop in addition to holding advanced discussions with both GE and P&WC regarding powerplants development. The airframer expects to propose a 90-seat turboprop to its board of directors in mid to late-2012 and plans for a 2016 EIS. Earlier this year Alenia’s chief executive Giuseppe Giordo told flightglobal that Alenia will launch a 90-seat turboprop programme regardless of whether EADS decides to or not, claiming that the Finmeccanica subsidiary has the capability to build its own large turboprop in Italy. ATR chief executive Filippo Bagnato has given indications that ATR’s 90-seat turboprop, if launched, will be optimised for SFC much like the current-generation ATR 72, and contain only the requisite speed increases to bring the aircraft to parity with jet aircraft on missions between 300-350 nautical miles (nm), with a cruising speed of around 300-320 knots. This speed increase will come in part due to the increased thrust of the newest generation of engines, whichever powerplant ATR chooses will be rated at at least 5,000 shp when compared to the 2,619 shp of the current ATR 72’s engine. While such a 90-seat development would be optimal for the vast majority of regional airlines around the globe, the cruising speed increases would not be enough to effectively replace regional jets, especially in the United States.

Bombardier meanwhile has left itself more flextibility with regards to its next-generation turboprop development. The manufacturer has no firm plans in place, but has pitched a 70-100 seats turboprop. While Aspire Aviation is not privy to the details of these proposals, for such an aircraft to effectively replace regional jets, the cruising speed of the new turboprop would have to be upgraded to around 400 knots. Because turboprops fly at lower altitudes than regional jets and as such have faster climb and descent times, a turboprop capable of cruising at around 400 knots would be close to flight time parity with regional jets on flights of up to 800 miles.

If Bombardier chooses to develop a 70-80 seat turboprop with higher cruise speed, they could conceivably use a 5,000 shp powerplant from either GE or P&WC. However, a 90-100 seats turboprop would need engines in the 6,000-7,000 shp range in order to increase the maximum take-off weight (MTOW) to handle 90-100 passengers as well as maintaining a cruising speed of 400 knots-plus. The increased MTOW of a 90-100 seats aircraft would likely necessitate a specific fuel consumption (SFC) increase which is partially offset by the increased fuel efficiency of the engine due to the added weight, an effect that would be especially pronounced if the cruise speed is up-gauged. This increase in engine fuel burn could number as large as 5%-7%, which would reduce the competitiveness of Bombardier’s next-generation turboprop when an ATR next-generation turboprop is optimised for a maximum fuel efficiency. Given that both ATR and Bombardier have estimated that the demand for turboprops in traditional roles over the next 20 years numbers greater than 1,500 frames, Bombardier can-ill afford to have any significant rise in the fuel burn of its Q400 successor. Thus Bombardier will have to implement significant weight reductions in order for its aircraft to remain competitive, potentially ruling out a simple re-engining of the Q400 NextGen.

Image Courtesy of ATR

In theory, Bombardier could make use of composite materials to enact such weight reductions albeit that path is fraught with significant risk. While the weight reduction potential is great, Bombardier also has to weigh the added costs of composite manufacturing, which is significant on a US$28 million aircraft at list price.

Notwithstanding this, the new generation turboprop from Bombardier will have significant fuel burn advantage over regional jets which Aspire Aviation estimates at 55%-60%. And that fuel burn advantage in and of itself gives the Q400 a significant advantage in the battle for fleet replacement, even if the differential is potentially cut to 35%-40% by a re-engined E-Series family aircraft.

Make no mistake, Aspire Aviation does not necessarily believe that the Q400 and its successors will necessarily overtake the ATR 72 in overall turboprop sales. The ATR 72 family remains optimised for fuel burn and given that the major source of growth in traditional turboprop sales is occurring in developing markets such as India and China where fuel prices are high, the ATR 72 is likely to retain a sales edge over the Q400 and possibly the Q400X aircraft. Aspire Aviation thinks that regional jet replacement could allow Bombardier to narrow the sales gap with ATR, however.

Over the past 3 years, the economics of regional jets have been put into questions by high fuel prices. Bygone were the days when Delta Air Lines operated 400 flights a day out of Cincinnati on CRJ-200s which was a viable operation at the time. Regional airline executives have to think boldly in order to ensure the viability of their capacity purchase agreement (CPA) operations. Furthermore, given the large fixed cost constraints of an airline operation, reducing aircraft operating costs with turboprops replacing regional jets is the best way, in Aspire Aviation‘s view, to achieve a meaningful cost reduction. The Q400X would offer an optimal solution with lower fuel burn which reduces operating costs and manageable cruising speed of 360 knots plus, if not better with a next-generation derivative. Therefore Aspire Aviation predicts that turboprop aircraft could potentially represent up to half of the future regional flying in the US. Perhaps 10 years from now, major US airline hubs will be littered with next-generation Q400s and Q400Xs, a veritable “Back to the Future” moment.

On Saturday, 29^th October 2011, Qantas, the Australian national carrier, took the unprecedented move of grounding its entire fleet of domestic and international aircraft as a “precautionary move” after locking out members of the Australian Licensed Aircraft Engineers Union (ALAEA), the Transport Workers Union (TWU) and the Australian and International Pilots Association (AIPA). On Friday, the ALAEA and the TWU had announced their intentions to escalate ongoing industrial action, and AIPA had given indications that it was considering further action as well.

Qantas is embroiled in an extended industrial dispute with its various employee unions, who are seeking pay raises of 3-5%, citing increases in inflation at a quarterly rate of over 3% in Australia in the past year. Its workers have been holding rolling strikes and refusing overtime work for weeks. The industrial actions, which had already cancelled more than 600 flights in the past few months, cost the carrier close to A$70 million Australian dollars, and continue to cost the carrier roughly A$15 million per week. According to Qantas chief executive Alan Joyce, Qantas customers were now switching to other carriers due to the dispute, with key high-value bookings on the east coast down by 25% year over year. Joyce further stated that:

“International bookings have also fallen, with November bookings nearly 10% down on where we expected them to be – when Qantas International is already making significant losses. Our customer research shows an alarming increase in people who intend not to fly with Qantas. In our domestic business that number has surged from a normal 5% to 20%. The intention not to fly with Qantas internationally has surged to nearly 30%,” Qantas chief executive Alan Joyce revealed.

Image Courtesy of ABC

The move to lock-out employees was made under the premise of the Fair Work Act. On Saturday, Australian transport minister Anthony Albanese said that the government would apply for a Fair Work Australia tribunal to make a determination on both the industrial action by the unions and Qantas’ management. The tribunal reached a decision in early Monday morning, with the Fair Work Australia ordering an immediate cessation of all industrial actions and called for the airline to resume flights as soon as possible. A limited flight schedule had resumed with the approval of Australian regulators by Monday afternoon, with full resumption expected Tuesday.

“Under the FWA laws Qantas and its long haul pilot, licensed engineer and ground handling unions now have a 21 day period in which to reconcile their differences, at the end of which the tribunal can consider an application for a further 21 day period for conciliation, or make a binding arbitration on the parties in the absence of an agreement,” Australia aviation journalist Ben Sandilands at Plane Talking said.

Qantas’ grounding of its entire fleet of 108 aircraft has already stranded close to 70,000 passengers at airports around the globe. While inconvenienced passengers have been rebooked and taken care of wherever possible, several thousand passengers were still indisposed in the days that followed as numerous flights on Monday were cancelled before Qantas returned to a full schedule on Tuesday.

Earlier this year, Qantas had announced a restructuring plan calling for the elimination of 1,000 jobs, the purchase of 110 Airbus A320 aircraft, including 78 re-engined A320neo (new engine option) aircraft and the establishment of a new premium carrier in either Singapore or Kuala Lumpur (“Moving Qantas International’s base to Asia not a panacea“, 17th Aug, 11). Given these moves, close to 35,000 Qantas employees had engaged in industrial actions over concerns that a significant number of jobs could be outsourced to cheaper Asian carriers. According to the Qantas Group’s full year FY2010-2011 financial results, Qantas International lost more than A$200 million last year.

Move could potentially do more harm than good
While Alan Joyce and Qantas Group’s chairman Leigh Clifford appear to have achieved their goals in the short term, the longer term effects could potentially be detrimental. Qantas is currently by far Australia’s largest domestic carrier, with a market share of close to 65%. Moreover, the carrier is the leading airline amongst business travellers who are especially drawn by Qantas’ utilisation of widebodied Airbus A330 and Boeing 767 aircraft between key business centres.

However, this action brings into question on that dominant share. For business travellers, an airline’s reliability is the most important factor of their considerations. But numerous business travellers have been inconvenienced by Qantas’ actions over the weekend though less than what would have been had the actions occurred during the business week. Many of these passengers have thus been forced into the arms of Qantas’ considerably more competitive international competitors Singapore Airlines (SIA), Cathay Pacific and Emirates and some of them could elect to switch allegiances to foreign carriers for future international travel.

Most importantly, the effect on Qantas’ share of domestic business travel has the potential to be far more deleterious. Earlier this year, Qantas’ primary competitor Virgin Australia introduced dual-class Airbus A330-200 aircraft into its fleet for domestic flights in an effort to improve its share of Australian business traffic. During the Qantas grounding which stranded thousands of domestic passengers in Australia, Virgin Australia was quick to respond by offering stranded Qantas passengers a discounted fare to complete their trip. It also planned to introduce roughly 45,000 seats worth of extra capacity in the coming weeks to help settle displaced Qantas passengers. This additional capacity will be brought through the implementation of additional trans-Tasman capacity by Virgin’s partner Air New Zealand (ANZ), allowing Virgin to reallocate resources to domestic flights. Given Qantas’ domestic operations remained as the most profitable domestic airline whereas its international unit lost over A$200 million over the same period, one has to question whether it really make sense for Qantas to hurt its brand amongst the very travellers who provide a large chunk of that profit.

Furthermore, Qantas has harmed its reputation amongst international passengers whose brand recognition is a powerful asset, some 25,000-35,000 of whom are expected to be stranded over its 2 days shutdown. Qantas carries just 18% of all international traffic, and the move will weaken forward bookings, perhaps even more than a prolonged industrial action would have incurred.

While there are unquestionably drawbacks to Qantas’ strategy, the fact remains that employee costs are a huge problem for Qantas, especially internationally. The Qantas Group, which is composed of Jetstar, Qantas Mainline, QantasLink, and JetConnect, has a cost per available seat kilometre (CASK) that is 50% greater than those of Singapore Airlines (SIA), 79% greater than those of Thai Airways International, and a staggering 106% greater than those of Emirates, according to Aspire Aviation‘s calculation from tonnage kilometre unit costs using industry body International Air Transport Association (IATA) guidelines. While these figures are impacted by the number of short-haul flights flown by the Qantas group, the fact remains that Qantas’ costs are inflated severely even if Jetstar’s lower costs are taken into account. If Qantas were to be competitive with its Asian and Middle Eastern rivals, it is clear that they cannot afford pay increases for its employees.

Even a wage freeze might not be enough to solve all of Qantas’ problems. Looking 5 years down the road, Qantas is due for a large increase in its non-employee operating costs. The airline’s 50 Boeing 787 Dreamliners should begin to enter the fleet starting early-2013, and the aforementioned A320neos will be delivered in the same timeframe as well. These will increase Qantas’ capital expenditure significantly, which requires strong operational profitability to prevent any increase in net debt. Its new fleet of Airbus A380 aircraft will end their maintenance “honeymoon” period by then, during which maintenance costs decrease due to an aircraft’s relative lack of flight hours and cycles. As a result, the fleet-wide maintenance, repair and overhaul (MRO) costs will increase similarly with Qantas’ 737-800s and the heavy maintenance checks required by the 747-400ER (extended range) fleet. Even with the significant fuel savings brought by the next-generation Airbus A320neo and Boeing 787 aircraft, Qantas will still face a rise in operating costs which will have to be offset by reciprocal reductions in employee costs. If Qantas were unable to sufficiently trim its labour costs due to Australia’s labour laws and union demands, it may have no choice but to outsource significant work to Asian nations in an effort to remain competitive.

Illustration Courtesy of News.com.au

Management not smart politically on compensation
Despite the validity of Alan Joyce’s claims regarding the unsustainable labour costs, he and Qantas’ management made a mistake Friday when compensation for Qantas’ upper management was decided at the company’s annual general meeting (AGM). At the AGM, roughly 97% of attendees voted for a A$2.1 million raise to Alan Joyce’s salary which takes his annual salary to A$5.1 million, a choice that was reflected in the salaries of other Qantas executives. This move infuriated Qantas’ unions, who have begun to use the A$2 million raise as a rallying cry to militancy, exemplified by the following line from an AIPA press release: “Here we have a chief executive who pocketed a two million dollar pay rise on Friday, stranded 68,000 passengers around the globe on Saturday, tried to pin the blame on the government on Sunday and then thinks he can claim victory and walk away scot-free on Monday.”

Make no mistake, the A$2.1 million raise earned by Alan Joyce and even his A$5 million salary are all but irrelevant when it comes to the company’s finances. For example, if that A$2.1 million was distributed evenly amongst the 35,000 employees engaging in industrial actions, each person would receive just A$60. The total compensation of all Qantas executives would not be worth much more if split evenly amongst front line employees either.

But to a union that is being asked to sacrifice cost-of-living driven wage increases, Alan Joyce’s words ring hollow, especially when he is given a whopping 72.4% raise while simultaneously claiming that Qantas’ international operations will not survive without wage freezes or even reductions. Across the world, there is increased agitation over income inequality as demonstrated by the various “Occupy Wall Street”-alike movements, and the large wage increases given to Qantas executives are further ammunition for the unions in their quest for increased compensation and benefits. For Qantas to be successful in reducing its labour costs going forward, its executives must be willing to participate in “shared sacrifice” with their employees and foresake pay raises, otherwise union-company relations will continue to denigrate into the standoffs seen today.

Qantas’ wounds partially self-inflicted
Over the past couple of years, Qantas has received plenty of criticism for its international network strategy. Its international competitors such as Singapore Airlines (SIA), Thai Airways, Cathay Pacific and especially Emirates and Abu Dhabi-based Etihad Airways, have flourished while Qantas seemingly languished.

There have been a pair of paradigm shifts in Australian international travel that have worked against Qantas: the onset of Asian travel, and the dispersion of demand to secondary centres beyond Sydney. For much of the modern jet age, international demand to and from Australia had been strongest to the United States, on the Kangaroo route to Europe and the United Kingdom (UK) market in particular, and to Japan. Qantas had planned its international network around these demand clusters hence the large numbers of Boeing 747s in its fleet accordingly. But in the early years of the 21^st century, the centre of the Australian demand shifted eastwards. While China with its variegated business interests in Australia is the largest source of growth, Southeast Asia, India and South Korea have seen staggering demand surges as well. And the ascent of Asian consumers was matched by their national carriers. Various Asian airlines have flooded the Australian market with capacity, more than tripling their available seat kilometres (ASKs) to the regions over the past 10 years. Caught flat-footed, Qantas has been slow to respond, even today it serves neither Beijing nor Seoul, two of Asia’s most important demand clusters, and what little expansion they have committed to Asia has mostly been done with Jetstar.

A second, more paramount development has been the “rise” of secondary Australian cities such as Brisbane, Adelaide, Perth, and even Melbourne as large travel centres. For many years Sydney as the largest business centre in Australia was the largest centre of international demand, and Qantas accordingly utilised a Sydney-centric network strategy. Recently however, both Brisbane and Melbourne have drawn even with Sydney in terms of international passenger figures. Even Perth, the smallest of Australia’s four major cities, has enjoyed a travel boom to Asia, driven by mining activities in Western Australia.

While other Australian cities bloomed, Qantas stuck doggedly to its Sydney-centric strategy. While it does have a decent international presence in Melbourne, it has none but a few token flights in Adelaide and Perth, and Brisbane remains a small operation relative to the size of its market. By forcing passengers to connect in Sydney with such connections often involve changing terminals, Qantas drove customers to foreign airlines in droves. Singapore Airlines (SIA), Cathay Pacific, Emirates and the likes serve all of Australia’s major cities with multiple daily flights, and travellers seem to prefer the convenient connections at Asia’s spacious hubs instead of travelling via Sydney.

Qantas’ Sydney-centricity is mirrored in its European network strategy, which with the exception of Frankfurt sometimes seems to force all passengers to make labourious connections onto British Airways’ (BA) flight at London Heathrow, on the Western edge of Europe. Thus it is little surprise that Emirates, with its large network of European destination with a hub located at a strategically advantageous position between Europe and Asia has quickly become the airline of choice to the European Union (EU).

Compounding Qantas’ woes is its fleet strategy. When Qantas chose A380s to replace their 747-400s instead of 777-300ERs, it put them in a position of being unable to take advantage of growth in Asia and in secondary Australian destinations. Over the past few years, Qantas has thus been unable to introduce flights between Perth, Brisbane, and Adelaide and Asia; because it does not have an aircraft with the adequate size or operating costs to do so. There are easily 10-15 Asia-Australia city pairs currently served by foreign airlines that could be served just as easily by Qantas had it ordered and operated the fuel efficient Boeing 777-300ERs. In the middle part of this decade when the 787 was selling rapidly, Airbus had plenty of room in its A330 order book. The A330-200 can serve most Australia-Asia routes efficiently, yet Qantas chose not to hedge its 787 order with a larger A330 order for short to medium-term needs. Once the 787 delays hit, Qantas was left with no mid-sized widebody growth aircraft for 2005-2011.

Yet a significant portion of Qantas’ troubles can be attributed to plain bad luck. In the wake of the 1998 Asian financial crisis when Qantas chose to order the A380s, one could not fault Qantas for failing to recognise Asia’s future growth potential. Moreover, Qantas did in fact realise that its home market was changing, and ordered close to 50 Boeing 787s, the first of which was expected to be delivered by 2007-2008. Unfortunately, Qantas had not counted on a more than 3-year delay on Boeing’s part and Qantas ended up looking un-prophetic, while in reality they had been as much victimised by misfortune as anything.

Image Courtesy of News.com.au

New Qantas strategy full of pitfalls
While Aspire Aviation applauds Qantas for recognising that its future growth potential lies in Asia, Qantas’ strategy of using an Asian premium carrier which Aspire Aviation‘s sources say Qantas is leaning towards a base in Singapore, is likely to be very tough to enact and difficult to profit from. Southeast Asia is certainly a fast-growing region, but in the same vein it is also a very competitive region, with the proliferation of low-cost carriers depressing yields significantly. If Qantas’ ultimate goal is to build a Singapore Airlines-esque premium carrier connecting Australian passengers amongst others around the globe, it will require significant investment with a likely marginal profitability. Singapore Airlines (SIA), with its superior service reputation is already the preferred carrier for high-yielding Singapore-based business travellers, without these passengers, Qantas’ Asian carrier would be forced to compete for connecting passengers with a myriad of other carriers, never an ideal situation for an airline built on premium service.

Moreover, one must ask what incentives do Australian passengers have to choose Qantas’ Asian premium carrier over Singapore Airlines (SIA), Cathay Pacific, and the like? Already in Australia, public sentiments are very much anti-outsourcing, and Asian premium subsidiary in the Qantas Group would rightly or wrongly be seen as a symbol of that very thing. And if Qantas is unable to ameliorate their current inadequacy amongst Australian travellers with this new carrier, then the new venture could turn into a branding mistake along the lines of Delta Air Lines’ Song endeavour in the United States.

Since Qantas retains significant power and brand recognition as well as loyalty in secondary Australian cities for domestic flights, it is not beyond the realm of possibility that Qantas could make flights to 3-5 Asian cities from each of Perth, Brisbane, and Adelaide work. Business travellers, who often choose Qantas for domestic travel and who pay a premium for non-stop flights in particular would jump at the chance to fly their favourite airline to and from Asia. Even with a fleet of A330-200 aircraft, Aspire Aviation feels that these flights could be far more profitable than those of Qantas’ Asian carrier. Qantas International can make money flying to and from Australia, but in order to do so, it must serve all of Australia, not just Sydney.

If Qantas is to remake its business, the one thing it absolutely cannot afford is a worsening of its already weak brand image within Australia. Their actions this past weekend have already triggered sharp criticism from the press and politicians alike, including Australian prime minister Julia Gillard, who was livid about the entire ordeal. Their actions, such as grounding the entire fleet and stranding thousands of passengers, have tarnished the reputation of the airline greatly. While Qantas is attempting to use a fare sale to alleviate its brand issues, it remains to be seen if they will succeed.

Last but not least, while Qantas chief executive Alan Joyce lamented the flying Kangaroo has no choice but to halt its worldwide flight operations in order to up the ante in the labour dispute with unions and put it to a head with the involvement of the Australian government and its labour tribunal, the jury is still out between the value of resolving the spat once and for all and the unpredictable costs of doing so, which may end up changing business travellers’ preference and damaging Qantas’ brand permanently.

Beginning November 1st, US low-cost carrier (LCC) Frontier Airlines will be shrinking its second largest hub in Milwaukee. Seven destinations will lose non-stop flights from Milawaukee, and a further 13 routes will see capacity adjustments in the month of October. In addition, Frontier will be reducing the total number of flights at the hub by 160 flights per week, more than 25% of the size of the hub.

Alongside the frequency and capacity cuts, Frontier has further announced that it will be cutting roughly 200 customer service, baggage, and ramp jobs in Milwaukee. Earlier this year, Republic Airways chief executive Bryan Bedford had indicated that Frontier was looking to restructure its business model so that the company would be profitable even with oil prices at a level above $100 per barrel. Frontier Airlines recently reported a US$32.8 million pre-tax loss for the second quarter of 2011.

Given the high price of oil, cuts to Milwaukee were all but inevitable. The majority of regional flights in and out of Milwaukee for Frontier had been scheduled on 37 and 50-seat Embraer ERJs. But the business case of 50-seat flying was nothing but non-existent as a result of the rise in fuel prices in the last few years, and given that the oil prices are expected to remain at a historically high level in the next few years, the seat-mile costs for the ERJs are likely to soar higher.

Furthermore, the revenue environment in Milwaukee is hardly conducive to running a hub with 50-seat jets, which requires large revenues to offset high seat-mile costs. The airport serves as a hub for Frontier’s low-cost competitor AirTran Airways which recently merged with the airport’s third-largest tenant – Southwest Airlines, and fierce competition between the two carriers has placed strong downward pressure on average fares. US Department of Transportation (DOT) statistics for the fourth quarter of 2010 indicate that Milwaukee had the 7th lowest fares in the nation amongst airports with commercial service. While such low fares benefit Milwaukee-based consumers, they do not provide enough revenue to sustain airline hubs, even those of low-cost carriers.

Image Courtesy of lowcosts.ru

In addition, Frontier has seen its competitive position when compared to AirTran slip in recent months. The most recent monthly statistics for Milwaukee show that AirTran and Southwest together hold a 35.5% share of Milwaukee’s passenger market, up from 32.3% in 2010. Meanwhile, Frontier passenger share has decreased to 28.7% from 31.4%. Moreover, AirTran and Southwest together have the largest share of origin and destination (O&D) traffic for 14 of the 22 largest destinations from Milwaukee, with Frontier having the largest share for only 3 destinations.

AirTran was at an advantageous position versus Frontier Airlines because it targeted larger markets such as San Francisco, Seattle, and Los Angeles with multiple daily flights, while Frontier largely ignoring these routes in favour of building a Midwestern connecting hub. AirTran was able to manipulate its use of relatively large Boeing 737-700 and 717 aircraft and drive fares down to a level where Frontier could not make a profit using E-145s. When faced with these challenges, Frontier attempted to counter with multiple daily flights on ERJs and E-Jets, attempting to attract more business travellers. But the markets where Frontier competed in the East coast were so oversupplied that Frontier was unable to gain enough of a fare premium to make the routes profitable.

And these recent moves might make it harder for Frontier to effectively compete in Milwaukee. The carrier lacks flights to 10 of the 25 largest O&D destinations from Milwaukee, which hurts mileage in the lucrative frequent flier programmes. Furthermore, the carrier is enacting cuts on many of its remaining routes on selected days of a week, citing peaks and troughs in demand.  Such a move makes sense for a low-cost carrier (LCC) running a point-to-point business model where each flight is expected to make a profit by itself. But Frontier has opted for a hybrid low cost hub-and-spoke model, where the emphasis is on network profitability as a whole. Cutting flights on certain days of the week makes it harder for them to connect passengers between spokes. Moreover, high yield business travellers prefer consistent frequencies, which will further hurt their competitive position and revenues for Milwaukee-based passengers. And Frontier does strong business connecting business travellers between the Midwest and slot-restricted Eastern airports such as New York La Guardia and Washington Reagan National Airport – business that could be undermined by frequency cuts to Midwestern destinations.

Destinations not served by Frontier Airlines are in bold

When Frontier Airlines parent Republic Airways Holdings merged Milwaukee-based Midwest Airlines with Frontier, the rationale was that a Milwaukee hub would diversify Frontier Airlines’ operation from being too Denver-centric. Denver, which is Frontier Airlines’ largest hub and home airport, currently serves as a hub for 3 carriers: Frontier, United Airlines, and Southwest Airlines. The three carriers are engaged in a fierce battle for passengers in Denver, and the competitive landscape there somewhat mirrors the one in Milwaukee. Given these competitive pressures, diversification was expected to serve as a hedge against further expansion by either United or Southwest in the Denver market. For instance, Midwest Airlines provided a second hub in Milwaukee, as well as highly-focused operations in Kansas City and Omaha.

But by merging Midwest Airlines into the Frontier Airlines brand, Frontier lost Midwest’s greatest asset – its brand. During the 1990s and early 2000s, Midwest built up a huge and loyal customer base in Milwaukee and the reputation of Midwest as a “hometown” airline with an excellent service such as those freshly made on-board cookies. However, Midwest converted its operations to a low-cost business model similar to the one employed by Frontier Airlines today in the mid 2000s. Yet due to the enormous goodwill it had built up, the carrier was able to maintain a revenue premium in the Milwaukee market, even after AirTran opened a hub at the airport in 2010.

But once the Midwest Airlines brand was dropped in favour of Frontier Airlines, what little advantage Republic Airways had in the Milwaukee market was largely eliminated. Core routes from Midwest hubs such as Kansas City-Minneapolis are being eliminated, and many of the routes being cut in Milwaukee have had Midwest Airlines service since the 1980s. And during that time, Frontier’s market share in Denver has remained constant at 21.4%, while Southwest Airlines has grown its share more than 2 percentage points to 20.7%. On many routes in Denver where head-to-head competition takes place, Southwest also holds a large revenue advantage versus Frontier and has already surpassed Frontier in the large O&D travel market.

In contrast, Frontier retains much of its brand power in Denver and Aspire Aviation expects to see a renewed focus on the Denver market from Frontier Airlines. There remain significant opportunities for Frontier to exploit its lower cost base in Denver, especially in competition with United Airlines. While Southwest has a presence in most large Denver markets, United Airlines holds a monopoly on the non-stop market to most smaller destinations. Frontier Airlines, with its lower cost base and fleet of Embraer E-Jets can step in to stimulate such markets. Aspire Aviation has identified 15-20 such markets in Denver currently not served by Frontier Airlines, that have small to medium O&D demand figures and high passenger yields. United Airlines, with a fleet of 50 seat ERJs cannot afford to match Frontier’s fares in these markets due to high seat-mile cost, and Frontier has already been successful using E-190s to similar markets like Madison and Knoxville, Tennessee. Furthermore, numerous small cities have taken advantage of the Small Community Air Service Development (SCASD) grants given by the US government to offer Frontier partial offsets of start-up costs for flights to Denver.

However, for such a plan to work for Frontier Airlines, Southwest Airlines would have to refrain from entering these new markets. Traditionally, Southwest Airlines has shied away from serving smaller markets given their propensity for sharing fixed costs at out-stations amongst multiple daily flights. However, Southwest’s strategy in Denver has differed from their standard network strategy, especially in terms of its quasi-hub structure. It stands to reason that they might shift into smaller Denver markets using their newly acquired fleet of Boeing 717s, as Southwest has committed significant resources into the Denver market, building up to more than 150 daily flights today from none in 2005.

Regardless, a large-scale shift in capacity towards Denver would signal a paradigm shift in Frontier’s route network. The idea of a hub-based low-cost model using 50-seat jets in an era of high fuel prices is essentially obsolete, and Frontier may have to evolve its business model to better match those of traditional low-cost carriers. Frontier Airlines has already begun flying charter flights in a deal with Apple Vacations, and has indicated that it wishes to pursue further low-frequency leisure flying. Only time will tell if such a strategy will pay its dividends.

Image Courtesy of Frontier Airlines

Figure 1.1- Changes to Frontier’s Milwaukee Operation

Figure 1.2- On-board Load Factor for Frontier in Milwaukee in June

Since its founding in 2007, Virgin America has often been questioned by not only airline industry analysts, but also some of its domestic rivals, on its business model. The Burlingame, California-based carrier, which is partly owned by British media mogul Richard Branson’s Virgin Group, has yet to achieve a full-year profitability in its more than 3 years of operation. In the first quarter of this year, VX reported a US$29.5 million operating loss, versus a US$22 million operating loss in the previous year’s first-quarter results. However, despite the losses, Virgin America has maintained a strong growth track and is expanding rapidly from its California hubs at San Francisco and Los Angeles.

Virgin America graciously allowed Aspire Aviation to interview their chief executive David Cush on 24^th August 2011. We covered a bevy of topics, many of which are detailed below.

Aspire Aviation‘s first question related to Virgin America’s order for the Airbus A320 neo (new engine option). The rationale behind the order, as well as some of the future plans for the type, is the reason for the question asked. Virgin America announced a firm order for 30 A320 neos alongside 30 of the existing A320s in January this year, becoming the first US carrier to order the European airframer’s re-engined narrowbody offering. Cush had this to say about why Virgin ordered the neos:

“Well, first of all the rationale. The rationale was largely economic, with a 15% improvement in fuel burn along with the sharklets. That is a pretty compelling economic argument. Especially with fuel where it is right now. The second thing, is that they are more environmentally friendly aircraft. They have a smaller carbon footprint. They have a smaller noise footprint, so they are just more environmentally friendly.”

Oil prices currently rest at around $90 per barrel with the industry benchmark West Texas Intermediates (WTI), and despite recent drops due to economic uncertainties, the long term trend is upwards with significant volatility. Given this environment, it is no surprise that Virgin America chose to replace their fleet with the far more fuel efficient A320 neos.

As for their future growth plans, they depend, as with many carriers, on the state of the US economy. Cush notes that the A320 neos, which “start coming in 2016,” and that Virgin has an existing fleet with “aircraft that come off lease at that point. So they [the A320 neos] could potentially replace current fleet A320s, but we haven’t made that decision yet. Our thought right now is that if the economy is good, then they’ll be used for growth.”

Interestingly, Cush revealed that Boeing was a competitor albeit being a considerably weaker one for Virgin’s replacement order, prior to its commitment to the A320 neo. The 737 MAX had not yet been launched when Virgin America committed to the A320 neo, however.

“Boeing was considered before the neo order when we signed a letter of intent (LoI) with Airbus at Farnborough in summer of 2010. Prior to signing that deal, which was for the standard A320, because the neo hadn’t been launched yet, we did have conversations with Boeing. But in the end, we are an Airbus operator, and we like having a single fleet, and that was a big part of our decision.”

The engine choice for the A320 neo was also asked, as Virgin America selected CFM International’s Leap engine over Pratt & Whitney (P&W)’s arguably more revolutionary PurePower PW1100G geared turbofan (GTF) engines that promise a 16% fuel burn saving in addition to a 20% saving in maintenance costs by eliminating 7 stages of life-limited parts (LLPs) when compared to the CFM56 engines (“Special Report: The engine battle heats up“, 10th May, 11). Cush responded by claiming that:

“We had very competitive engine-maker offerings, as a matter of fact; Pratt was actually in the lead for most of it, and then CFM closed it right at the end, I think they were very motivated to get some sales given the fact that Pratt had such a lead. What I’ll say for the economic analysis is that our internal analysis did not show a significant difference in maintenance operating costs between the two products. I’ll also say that the fuel burn was somewhat similar, the fuel burn savings. So looking at a standard economic analysis, the engines were very similar. The thing that we got from CFM is that they offered many more [service guarantees] than there were with Pratt. Obviously as an airline executive, you never want to use the guarantees, you hope the engine performs as advertised, but it’s nice to know that they’re there. The second thing in all honesty, was in the end CFM and GE have been very good partners, very supportive partners we have a great relationship with them. These are 20 year decisions you make. The Pratt guys were great also, but we’re very comfortable with CFM and GE.”

The Airbus A320 variant is not, however, the only aircraft currently in Virgin America’s fleet. The carrier operates 10 A319 aircraft alongside 30 A320s. The replacement plans for these aircraft and whether they could potentially be replaced by the A319 neo have also been asked. Virgin America chief executive David Cush had this to say in response:

“We’re really not interested in the A319 neo. The A319s serve a very specific purpose in our fleet. The reason we have A319s is because the current A320 cannot fly a full payload from the east coast to the west coast during the winter, with the winter weather. But the A319 can fly it. Once the sharklets come on, which will start in 2013, the A320 will actually be able to fly a full payload and once the neos come on, with the neo range, they’ll be able to fly a full payload. So the reason for having the A319s in the fleet essentially goes away.”

From fleet planning, Aspire Aviation moved on to discuss Virgin America’s route network. The carrier recently inaugurated service from its hubs in San Francisco and Los Angeles to Dallas and Chicago in December 2010 and May 2011, respectively. Aspire Aviation mentioned that the onboard load factors were relatively low for the Dallas route at close to 67% when compared to the other routes, and asked whether this was due to the aggressive pricing from rivals AMR Corporation’s American Airlines (AA) and United Continental Holdings, both of which have hubs and strongholds in Chicago, San Francisco and Los Angeles, with AA having a hub at Dallas Fort Worth as well. Cush responded by saying:

“There certainly has been aggressive pricing, but we’ve been the pricing leader. So we’re the carrier that’s introducing the aggressive pricing. What American and United have done is they’ve had a disproportionate reaction in terms of capacity. United went from, in Chicago-San Francisco as an example, went from 11 frequencies a day to 17 frequencies a day; all 6 of those started the day we started service. American went from 15 flights a day from Los Angeles to DFW, to 20 flights a day. So their response has been on the capacity side. We’ve been the guys that have dropped the fares.”

However, when asked about forward bookings for the rest of the year on these two routes, Virgin America chief executive David Cush related that,

“As far as load factors go, we knew that DFW was going to be a long tough slog, because of American’s dominance. We had pretty good loads during the summer in the 80s [per cent range], and we’re pretty confident going into the fall. So we weren’t surprised by the amount of time it took us to get traction in DFW. I worked for AA for 22 yrs, so I know how that goes… We went in with our eyes wide open. They’re looking very strong for Chicago, I would say for DFW they‘re matching our expectations; they’re booking at about system average. For Chicago they’re booking above the system average.”

Image Courtesy of Virgin America

He also stated that he did not believe that American Airlines and United Airlines’ recent expansion of regional jet flying to Western and Mid-continent destinations would pan out, pointing out that American and United would often be competing against mainline aircraft from Southwest Airlines on these routes.

The next question dealt similarly with competitive pressures, asking what effect Spirit Airlines’ west coast expansion would have on Virgin America. Cush opined that Spirit’s entry would not have as big of an effect as some analysts fear, stating:

“I would make a couple of observations. One is, I think Spirit is being smart. They’re seeing if their model works in the West, it seems to work very well in S. Florida and the east. So I think this is a logical thing for them to do, given that they want to grow the airline. As far as their impact on fares, I think we’ll have to wait and see. They have a pretty different model, in that their base fare is low, but when you add up everything on top, their total PRASM [passenger revenue per available seat miles] is pretty close to where the rest of the low cost carriers are. Any time there’s a new carrier, that drives prices down, and that’s better for the consumer. So I think that they’ll certainly have an effect on the market. I don’t think that it’ll be any different than the impact of any other low cost carrier entering the market.”

In spite of being based on the West Coast, Virgin America’s presence in Western cities beyond Los Angeles and San Francisco is limited to Las Vegas, San Diego and Seattle. Cush foresees the airline entering more intra-West markets as they continue to grow the fleet. But expansion will continue to destinations across the country as well, mostly in larger business markets.

Internationally, the carrier has faced a mixed bag of performance with Mexican routes holding up well, while routes to Canada did not match expectations. Virgin America commenced service to Toronto on 23^rd June, 2010. The service last less than a year, with service being dropped on 6^th April this year. Cush said that Virgin America prefers to “stimulate” new markets that it enters, and that while the Toronto routes performed fine during the summer months, they were not “stimulated” during the winter months, when Canadians prefer to travel to the Caribbean due to “tricky” winter weather in California. However, despite these temporary setbacks, Cush did say that he expects to “see a Virgin tail back in Canada within a year.”

In contrast, Cush spoke glowingly about Virgin America’s flights to Mexico. I questioned whether the drug-related violence has hurt the performance on these routes, to which Mr.Cush responded:

“The routes are doing well; we’re in Cancun and we’re in Cabo. The resort areas in Mexico, with perhaps the exception of Acapulco, are largely isolated from some of the violence throughout the country. Demand to Mexico is still very strong, and the best evidence I can give you is that we are launching a new route into Mexico, we wouldn’t do that if there was an impact of the cartel-related violence in the tourist areas. We are going into Puerta Vallarta and we think it will be every bit as successful as Cancun and Cabo are. And our plan is to continue to grow into Mexico.”

Cush categorised Puerta Vallarta to which service will start on 2^nd December this year and the other destinations as good winter routes, likening them to the Carribbean and South Floridian operations of Spirit and JetBlue on the East Coast. However, he does not foresee an expansion into the Caribbean or Central America in the near term by Virgin America because those routes are very long from the US west coast, thereby costing more in fuel and potentially presenting operational challenges.

Beyond the route network, Aspire Aviation expressed concern about Virgin America’s cash level, which hovers between US$25 and US$30 million, which is low for a carrier with quarterly revenues of US$200 million. Cush stated:

“We essentially manage our cash to about a US$20-30 million dollar balance. We also have irrefutable lines of credit with our shareholders, that give us significant financial backing. But they’re also expensive, any time you draw on a cash line of credit, then you’re paying interest, and of course the way the markets are today, you don’t make any interest on your own cash. So we manage very tight on the cash side, but you’ll also see in our press releases that we talk about what we call total liquidity, which are undrawn portions of irrevocable credit.Virgin America had total liquidity of US$54 million in the first quarter of 2011, though in past quarters the figure has been closer to US$100 million.”

From a passenger perspective, Virgin America is one of the most beloved US airlines. Famed for its superb onboard product, Virgin America recently won the prestigious award for all around onboard experience at the Passenger’s Choice Award at 2011’s Airline Passenger Experience Association (APEX) Exposition, held this year in Seattle, Washington. Cush believes that Virgin America’s product gives it an advantage over competitors, noting that Virgin America’s passenger revenue per available seat mile (PRASM) is higher than that of its low-cost competitors.

Virgin America is certainly a quandary for US airline investors. Despite marginal financial results, the carrier continues to grow at an astronomical rate, with revenue increased 37% year-over-year in the first-quarter of this year. Its new fleet order positions it well for the “new normal” of high oil prices, and the carrier is being smart about how it grows its capacity. But they still face significant competitive challenges, with Virgin’s home market of California being fiercely competitive.

Last but not least, if the reaction of the legacy carriers to Virgin’s Chicago and Dallas routes is any indication, then Virgin may be in for a long and protracted battle.

Aspire Aviation wishes to thank Virgin America’s Media Relations team for arranging this interview.

Image Courtesy of Jean Luc