Come fly with me, let’s fly, let’s fly away…if you can use, some exotic booze…there’s a bar in far Bombay.” If Frank Sinatra had to take a 20-hour flight with delays and lost baggage, maybe he would have sung a different tune.
The ever elusive profitability of the globally ill-fated airline industry is yet to find a solution. Although we are aggressive proponents of free market capitalism, airlines are where we would make an exception. Time and again, globally, the airline industry has defied stability in the face of market forces. Unfettered pricing wars, bankruptcies, maintenance issues, delays have become commonplace in an industry which once catered to premium travel. Bringing back regulation and treating this industry like a utility that needs a certain return on its capital is perhaps the only way out globally.
Until 1978, the US airline industry was regulated for fares, routes and schedules. Deregulation ushered in an era of new routes, carriers and lower fares. While the number of passengers since then has grown several times over, fares have also declined dramatically. However, the business of undercutting is never in the interest of all.
In the face of intense competition, rising costs and with little manoeuvrability around fares, the woes of the US airline industry have become a mainstay over the past decade.
Discussions about the feasibility of the hub and spoke model and such pale compared with the need to establish a minimum cost of recovery for such a capital-intensive business.
Maybe this industry needs to recognize, once and for all, that it does need a minimum fare to transport a passenger from point A to point B. After all, this industry is a capital-guzzler and investors will always demand a return on their capital. Ironically, airlines were guaranteed a return on capital by the government in the era of regulation. For a cyclical business, the average return on capital through a business cycle tends to be a better gauge of profitability, whereas for the airlines, in most cases, the return on capital even during up cycles has failed to justify their cost of capital.
Of course in the US, the airlines will always have the option of a “bailout” or better still to become bank holding companies!
Volume growth at the expense of pricing and hence profitability is ingrained in the industry’s psyche. This is best illustrated by the experiences of this industry in Brazil and China—both fast growing markets until recently, yet with completely disparate industry structures.
Until 2001, Brazil’s airline industry was dominated by the legacy government carrier, Varig (which, ironically, is bankrupt now) and TAM. GOL, the low-cost carrier, joined the fray in 2001. Now, GOL owns Varig, and TAM and GOL operate in a virtual duopoly.
In China, by contrast, the myriad of air carriers that had evolved from the one state-owned carrier merged to form the Big 3—China Southern, Air China and China Eastern. In 2005, the government allowed private companies in, resulting in a slew of upstarts.
So here, on the one hand we have Brazil with super stringent norms on new entrants and routes and, on the other, China with quite a fragmented industry. The result? Crushing price wars in both countries.
Another counter-intuitive issue with the industry, in spite of its enormous capital needs, is the general belief that this industry operates first for the benefit of customers, profitability and hence shareholders come a distant second. Relentless fare declines in an industry that uses highly complex machinery and also has to adhere to the highest safety standards are never a cause for concern.
The recent decline in jet fuel costs in India has been promptly passed on to the consumer by both Kingfisher Airlines Ltd and Jet Airways India Ltd. Another fascinating aspect are the promoters, private equity firms and others with deep pockets who are always willing to invest in the industry—for, of course, this industry that has proven to be a global disaster will now chart a different course! This has, so far in India, made it possible for the vicious cycle to continue—the airlines burn cash and as long as these eager investors exist, capital raisings continue.
The oil threat among other costs is imminent; to stay afloat airlines could raise fares but competition renders that impossible. Consolidation would seem like a plausible solution on the face of it—the number of carriers would reduce, seat capacity would go down, or will it? Not all mergers offer synergies, a case in point being Delta Air Lines Inc. and Northwest Airlines where the overlap was minimal. Additionally, as is the case with Brazil, only two airlines are enough to start a price war. The Indian industry itself has consolidated significantly in the last two years; any real benefits of the combinations are yet to be seen.
Deregulation has lent instability to an industry which serves to make the world flatter. Maybe it would be in the broader interest if this industry went back to the era of regulation. Not that the system was flawless but at least with a guaranteed return on capital, airlines wouldn’t be forced to cut corners and compromise safety a la Southwest and American Airlines.
Rajeshree Varangaonkar and Bharat Indurkar have day jobs with US-based hedge funds. They write every other Thursday. Send your comments to email@example.com