CAPA Aviation Outlook 2019: The distribution (r)evolution accelerates
As fuel prices deliver short term relief, demand is the big unknown in the year of the pig.
It's become almost a truism since the advent of President Trump, the British folly of an imminent Brexit, the rise of European populist politics, and rising debt challenges, to say that the coming year will be characterised by unpredictability.
The wild 2018 end of year share market oscillations are another illustration of investor anxiety. These factors are neither conducive to industry planning nor to encouraging consumer confidence.
Fuel prices and exchange rates will drive short term profitability
For aviation, the additional, and interlinked issues of fuel prices and exchange rates will however continue to be the foremost drivers of short term profitability. The importance of this input was clearly illustrated when steeply higher prices in the first half of 2018 quickly drove down profits for many unhedged airlines.
Then in 2019 the below-the-surface revolution in how tickets are sold will begin to impose its influence on the shape of the industry. The tip of the new distribution iceberg is just starting to surface and will soon drastically modify the sales process, even eventually affecting the way airlines operate. Only a handful of full service airlines fully appreciates this tectonic shift; they are mostly the larger ones, perhaps prefacing a new shift towards restoring their supremacy. LCCs have often enjoyed more flexibility, but as they hybridise, they too will be challenged.
Low fuel prices offer a period of relief
As the new year begins, the promise of lower than expected fuel will be a vital bonus. Against earlier 2019 predictions of a range of around USD60-80 or above, the current level in the USD50-60s for Brent Crude offers a bonus that few airline CFOs would have hoped for two months earlier.
Nobody really has a clue where prices will go, but the opportunity to top up hedges for the next year or so was there for the more astute operators when the price level suddenly dipped in 3Q2018. (The recent sudden price drop against expectations of higher levels may also bring nasty surprises for some intemperate hedges, as the tide goes out and mark-to market calls are made.)
On the positive side, there is a widespread feeling that the earlier spell of very high oil prices has helped airline managements to entrench improved sustainability in the face of these external headwinds. Nonetheless, airline fuel costs remain a testing variable.
Airline share prices, although affected by many other features, illustrate clearly the market view of future prospects as oil prices fluctuate.
The following graph suggests the relief the market felt, as predictions for further oil price rises subsided and levels dropped from the low USD80s to USD50. From Nov-2018 onwards a torrent of other impacts destroyed the symmetry, but airlines and their market valuations are always subject to a horrifying range of external factors.
The inverse relationship between industry share prices and the cost of oil
Demand: growth remains solid but may be slowing. Asia is where the action is - but not the profitability
After a couple of years of benign global economic conditions, demand in 2019 looks likely to moderate.
It is this side of the ledger that is most difficult to predict, given the political and global economic factors now in play.
Asia is the fastest expanding and most innovative (and perhaps riskiest) market. But, according to a late-2018 report by the World Bank, economic growth in the world’s second-largest economy is poised to slow to 6.2% next year from 6.5% at the end of this year, as the drag from China’s economic concerns becomes clearer in coming quarters.
Trade disputes or trade wars will do nothing to improve confidence – although, to date, any impact on air travel or aviation regulation specifically has been insignificant. What it will do for demand is something else.
CEO confidence is sliding
Among other indicators, the US Conference Board announced US CEO confidence in the month of Dec-2018 declined again and is at its lowest in two years - although slightly more CEOs hold a positive outlook than negative.
And according to the Board, despite a still-healthy sentiment, the consumer confidence index also slid a little in Dec-2018, following falls in previous months. Consumer expectations for job and business conditions also fell. From these findings the Board concluded that “While (US) consumers are ending 2018 on a strong note, back-to-back declines in Expectations are reflective of an increasing concern that the pace of economic growth will begin moderating in the first half of 2019.”
Meanwhile however, US consumer spending over the Nov-Dec period was the highest in six years, up more than 5% over the previous year. The UK was a different story, where spending over the period was actually in negative territory year on year, Brexit-inspired or not. (One exception was London, where the lower GBP reportedly attracted cross-channel shoppers.)
Recession is merely a matter of “when”, not “if”
Not only are “trends” changing, but there are also varying interpretations of those trends. Some indicators have recently become quite pessimistic. According to an analysis of Duke University’s quarterly survey of CFOs by Merrill Lynch in late 2018, “Financial markets and CFOs think the world economy is in real trouble.” This view may be an outlier, but Merrill Lynch also predicted the world monetary base was “likely to shrink 4.6 per cent by December 2019, unprecedented in 37 years”.
The Duke University survey recorded 48.6% of surveyed US CFOs believed the US would enter recession by the end of 2019. More tellingly, the results of the survey suggested recession is not a matter of whether, but of when; 82% of CFOs believed a recession will have begun by the end of 2020.
In Asia, economic uncertainty was found to be the top concern. Confidence among surveyed CFOs in that region dropped 8 points in 3Q2018 to 52, close to 2008 lows.
IATA meanwhile, in its Dec-2018 Airline Industry Economic Performance Report, noted that “Airline CFOs and heads of cargo reported in October that they were significantly less positive about future growth in air travel, and were less positive about cargo. This reflects increasing worries amongst business worldwide about economic prospects.”
The very fact that there are such varying and cautionary projections itself suggests a turbulent period in prospect, with a trend towards consensus that 2019 will be a much more difficult year than 2018.
High traffic growth in 2017 and 2018 has created a more price sensitive consumer profile
The unusually high traffic growth rates of the past two years have been the result mainly of a modestly benign global economic climate and low fuel prices which have allowed airlines – in a competitive market – to price aggressively. The result, as we noted last year in our 2018 Outlook, was to create a consumer profile that is increasingly prices sensitive.
The implications of that are that any attempt at raising fares is likely to be met by resistance and traffic slowdown, a feature already witnessed in some Asian markets.
Using facts to project the future: fleet orders and deliveries
In an industry with so many variables, any assessment of the future, even looking only a year ahead, is riven with challenge. But there are some indicators that predict outcomes more accurately than others.
One of the more reliable pointers is aircraft orders. These suggest capacity (supply side) conditions in the year to come.
Admittedly delivery dates can alter or orders be changed or cancelled. It’s also important to recognise the level of replacement vs net fleet additions.
But even with these cautions, the sheer contrasts in scale of orders and deliveries speaks volumes.
Where the Asia Pacific operating fleets are rapidly approaching North America’s dimensions, the fact that the region has no less than twice the number of deliveries planned for 2019 speaks volumes - both for global aviation and for capacity levels in AsiaPac. The net effect contrast is even greater in practice, as North America’s often much older fleets imply a higher concentration of replacements.
Aircraft delivery dates for US airlines 2019 and beyond
Asia Pacific aircraft orders suggest oversupply in 2019
Against an existing AsiaPac fleet of 9,700 aircraft, there are some 800 aircraft scheduled for delivery in 2019, of which nearly 80% are destined to four large LCC groups. This is to occur in an already crowded and competitive market, where profitability was becoming challenging in 2018.
As many of the region’s airlines grow rapidly, there has been a rash of sale-and-leasebacks to support cash flow, as well as establishment of airline leasing companies, designed to provide outlets for any excess units.
Inevitably this is a much less orderly market than the longer established regions and a substantial element of strategic expansion is occurring, as airlines seek to ensure they are in a position to secure adequate market share in the near future.
The contrast with US airline order books is stark, and made more so by the much greater age of the US fleet (implying the need for more replacement than growth). Only a little over 350 aircraft are scheduled for delivery in the US in 2019, against an existing fleet of 8,600.
Aircraft delivery dates for Asia Pacific airlines 2019 and beyond
Regional differences can be stark
Equally stark are the respective growth rates and profitability in the contrasting regions. IATA is forecasting US airline profitability of USD16.6 billion in 2019, or a per pax profit of USD16.77 and a breakeven load factor of only 57%.
In AsiaPac though, according to IATA the profit per pax is only USD6.15 and breakeven load factor 11 points higher, at 67.7% (although, unlike the relatively standard profitability in the US’ oligopolistic market, results vary widely from country to country in AsiaPac).
In Europe, where a battle royal is playing out between full service airlines and their subsidiaries and the larger powerful LCCs, the 2019 breakeven load factor is projected to be even higher, at 70.1%. For both Europe and AsiaPac, fortunately the actual load factors tend to register at around 4% points higher respectively.
Increasing pre-eminence of LCCs in Asia
The order books also illustrate the pre-eminence of LCCs in the Asia Pacific region, emphasising the price profile of the region – in turn creating consumer expectations that can make it hard for foreign airlines to compete on long haul, especially on the North Pacific.
Almost half of the world’s LCC orders are in the AsiaPac region.
The rise and rise of long haul low cost – narrowbody
Long haul low cost operations are now well entrenched and progressively developing hybrid models, while retaining the low cost initiative. Until the arrival of the new, larger narrowbody equipment, these were strictly widebody operations, notably with A330s and 787s.
But over the past two years several LCCs have begun deploying narrowbody aircraft on long haul routes, driven by the introduction of new generation aircraft and engine technology. European LCCs have been at the forefront of using re-engined narrowbody aircraft on long haul routes, particularly across the Atlantic.
The arrival of smaller aircraft types with a strong cost profile is beginning to open up new avenues for route planners, as much smaller gateways and city pairs can become commercial, giving rise to a new surge in connectivity.
Norwegian was one of the pioneers, using a new fleet of 737 MAX 8s to launch several new transatlantic routes in summer 2017. Norwegian also acquired 30 A321neoLRs for use to expand further in the transatlantic market from summer 2019. A common flight time for this type of service is seven hours and more. WOW air, now being welcomed into the Indigo Partners fold, was another long haul narrowbody LCC pioneer, becoming the first European A321neo operator in Jun-2018, also operating on the north Atlantic.
It’s not just LCCs for whom the new types are attractive. Former LCC WestJet also operates narrowbody aircraft across the Atlantic although several LCCs are expected to follow over the next few years, taking its first 737 MAX 8 in late 2017 and launched Halifax to London and Paris in late Apr-2018 and late May-2018 respectively.
In Asia Pacific regularly scheduled narrowbody LCC routes are generally limited to six hours, although Indonesia’s Lion Air currently operates 737 MAX 8s on several charter routes to China of around seven hours. Garuda subsidiary Citilink also currently operates four charter routes to China that are between six and seven hours. And Qantas LCC subsidiary Jetstar is to receive 18 A321neoLRs in the next few years.
All of these developments have the potential to reshape network planning in the medium-long haul market - almost to the extent that the Gulf carriers were able to do as very long haul widebodies arrived in the market in the 1990s.
The invisible ingredient in the airline industry: all change!
But, even with the operational turmoil occurring in the highly competitive airline market, there is an area which is much underrated and rarely visible to the public. It is the “distribution” of the airlines’ products ie how tickets are sold.
Changes in this area are about to turn the airline business on its head. And it’s going to happen in the next two years. It’s technology enabled, but like most tech developments, it’s not as simple as that.
Airline managements and structures are usually neither equipped to understand what’s happening nor, more importantly, how to deal with it. (And, perhaps as importantly, neither do aviation market analysts who are much better equipped to run traffic and financial data on complex models than to get their minds around fundamental strategic change.)
The system for selling tickets is about to be savagely disrupted
A little background: for an industry obsessed by big boys’ toys, and constantly bemoaning the inability to generate decent returns on capital invested, most airlines have been notoriously bad at doing the bits that earn money.
That is, selling their products.
There are lots of reasons for this, some of them beyond the airlines’ control. It begins with the restrictions on their ownership. Having to be nationally owned and unable to establish in other countries means that establishing a global brand is impossible.
The same restrictions don’t apply to intermediaries, who can establish anywhere and sell almost any airline’s tickets.
Intermediary paradise as airlines just flew aeroplanes
In this environment, intermediaries proliferated. The advent of the internet only magnified the possibilities for other parties to dominate public visibility of the products the airlines were hawking – mostly similar seats on similar aircraft, at similar prices.
This led easily and predictably to the commoditisation of the airline product. Airline brand promotion and frequent flyer programmes did a bit to recapture customer loyalty, but it’s still pricing that dominates consumer behaviour today.
The role of global distribution systems, which combine schedules, seat availability and prices from different sources, then provide this information in real time to travel agents, became all-powerful. The airlines effectively abdicated their connection with their customers, existing and potential.
These GDSs arrived (as airline owned computer reservations systems) several decades ago and, despite numerous upgrades, their technology limited the flexibility of the information they can deliver to agents. With the internet, online travel agents more recently emerged, permitting even greater transparency of pricing – and of price-based competition.
Then the airlines woke up
As technology intruded more rudely into the airline system, several things occurred: airlines began to wake up to the fact that they needed to be more than transport providers. Now they could use data to profile customers, also opening up the potential; to deliver “rich content” (not just fares) in the sales process.
But the frustrations from their decades of inaction mounted as the barriers to using the new technologies refused to budge. The technology was now available, but the vested interests weren’t about to let it happen. If the airlines wanted to regain control over their end users, something had to give.
For a while there was a hope that airlines could distribute all of their product online, direct to the customer, from “airline.com” sites, just as the newer LCCs had begun to do. But there was a ceiling to the proportion of sales possible that way, particularly for long haul airlines which weren’t well known outside their home country. That wasn’t’ going to be the answer.
The arrival of NDC and where it is leading
IATA had previously focussed on attacking the GDSs for their confining lock-in contracts and their high charges, much of which were on-paid to agents to keep them happy. Some individual airlines moved to extricate themselves, but it was risky, costly and didn’t really solve the long term problems.
Eventually, seeking to establish some industry standard to help airlines transition to a new world of distribution, the association devised the New Distribution Capability, NDC.
This doesn’t offer a solution in itself, but it has served at least two causes.
First of all it has provided a rallying point for airlines and intermediaries, often highlighting the immensity of the problem facing the industry as it seeks to evolve to a new distribution environment.
The IATA Promotion
Direct connections are the goal, with lots of communication
In practice the NDC points the way to a common interface, using the direct connection capability that is now possible using APIs. Basically an “application planning interface” allows two different sets of systems to talk to each other, in other words, without the need for costly intermediaries.
So, for example, through an API an airline can provide all of its data (schedule availability, fares etc – and, vitally, all of that additional “rich” content) - directly from its own system into the end user’s, or at least the agent’s.
The problem with that though is that this API-based process is basically bilateral; that is, it means dealing one on one, and for that to happen, every outlet large or small must have the technical ability to use this direct interface, with its mass of data.
Selling tickets just ain’t easy
That data isn’t just fares and schedules. It includes a whole range of simultaneous, or trailing, transactions, like selling platforms (payments), mid-office systems, reporting systems for clients and back office systems; allowing refunds, changing itineraries and all sorts of permutations of any sales process.
Given the diversity of tech activity around the industry, there is a multiplicity of special “solutions”, for example helping simplify payments. For the smaller agents (or airlines), embracing all of those in a way that can interface with the new mainstream models is a maze they will never escape.
Without getting into the further technical details, it should be obvious that all of this means essentially reworking all of the previous systems – a bit like resurfacing a major runway during peak hour, for those who haven’t yet transitioned to the realisation that airlines should be more than transportation vehicles.
IATA’s initial NDC goal, and it seems to be within reach, is for “20-20-20”, to have 20 airlines making 20% of their sales by 2020. The NDC “leader board” is looking good for that target. But really that’s just the beginning of a complex and confusing few years for most industry participants.
And now for the disruption…
This slow moving distribution animal has a very long tail and a highly complex physiology. It’s going to take an awfully long time before everyone along the tail can coordinate and adapt their activities.
Many simply won’t be able to adapt; indeed, many are yet to realise that the changes occurring now are so far-reaching that their extinction is imminent. Some of them might even be airlines.
So far, it is notably the largest of the full service airlines who are best equipped to make the conceptual, technological and commercial decisions necessary to adapt. That alone will shift the balance of the industry.
But there is a whole host of other players – inside and outside the industry – who will encounter massive change over the next couple of years.
For many of the “outsiders” (new applications, new systems), this spells opportunity; for many of the incumbents, it will not be an attractive future.
Travel agents, travel management companies, GDSs, OTAs, as well as airlines, are all in the firing line unless they appreciate the enormity of this new world.
But there’s also a new world of wonders for the ones who do get it.