Disruption in the airline industry. It will happen sooner than we think: Part 1

This two part report is a slightly modified version of an article appearing in the Nov/Dec-2016 edition of CAPA's Airline Leader journal.

Part 2 of the report is at Disruption in the airline industry. It is coming, faster and bigger than you think: Part 2

Addressing the ecosystem of creative disruption

The Bank of America Merrill Lynch recently identified "three ecosystems of creative disruption": the "Internet of Things is expected to be a USD7 trillion industry by 2020, the Sharing Economy has a potential market opportunity of over USD450 billion, and local consumer On-Line Services has a potential market opportunity of USD500 billion.

These ecosystems are the catalysts for creative disruption", it argued. "They reduce barriers to entry for a new business down to imagination and the ability to maximize the ecosystem; they allow companies to improve productivity, reach new customers, introduce products and services faster than ever before; and they level the playing field between large, small and new companies, redefining competitive advantage." ¹

Against this scenario, airlines have remained largely un-disrupted this century, while all around them has changed. This review argues why that status quo is likely to change profoundly. It will first address the regulatory system and why that will change, in large part due to the emergence of China, and then assess the parallel and complementary role of data analytics, personalisation and consumer empowerment.

As the two coincide, the outcome will be unexpectedly disruptive.

PART I. The undoing of bilateral airline regulation

Market entry to the airline industry remains relatively easy, with low capital needs; but market exit by incumbents is remarkable for the little that has occurred. Whether protected from destruction by power inside a sealed-off domestic market, by bankruptcy laws allowing costs to be artificially discarded, by regulatory protection internationally or by direct subsidy, the fact remains: market exit by legacy incumbents has been much more the exception than the rule. Yet that is starting to change. The process of natural selection is slow, but accelerating.

For decades, operating aircraft was really the main activity of the industry, where engineers ran airlines. In the case of legacy airlines (that is, companies that existed prior to this century and perform full service operations), the silo nature of this operating vs selling distinction has been perpetuated across the company, much to the disadvantage of the airline, as customer relations and data analytics become increasingly important.

Economic and Safety regulation are endemic, but one is more necessary than the other

Operationally there are, in turn, two forms of regulation: safety and related, and economic. Little needs saying in the area of safety regulation, although because of its overriding importance, safety's untouchable halo can sometimes be a useful weapon for those wishing indirectly to impose economic restrictions - as in the case of US pilot unions opposing the operations of Norwegian International across the North Atlantic.

There they creatively argued among other things that "flags of convenience" were just around the corner (and therefore a loss of safety oversight) if Norwegian were allowed to operate from Ireland. Reality promises otherwise, but it was sufficient to send the US Department of Transportation (DoT) and Department of State (DoS) into lengthy hibernation.

It is the economic regulation that is so overweening as to be a destructive force, quite opposite to its original purpose. A main reason that an economic regulatory system established in 1945 can still exist in 2016 is the constant intrusion of nationalism. Moving from a mentality of "flag carriers" and all the nationalistic features that evokes inevitably takes time.

Legally, the foundation is in the need for bilateral approval of air services and the persistent requirement for "substantial ownership and effective control" to reside in airlines designated to operate under these agreements.

Surprisingly, the bilateral system will change fundamentally by 2025.

Despite decades of inertia, new forces are at work, operationally and commercially that are coming together to disrupt the airline industry. From a range of sources, momentum has been building that signals the potential for a remarkable evolution in international ownership restrictions.

The starting point is with the underlying currency of the bilateral trading system: travellers. That is, ownership of market potential inside "our" boundaries and the fact that "our" travellers spend money with you. We will, so the principle is applied, give you a limited licence to exploit a little of "our" market internationally - provided you have something to offer in return. Meanwhile we will of course prevent you from operating within our domestic market. In other words, the rich and powerful call the shots - that's mostly how international law works.

It has been called mercantilism, an elaborate description for something that amounts to a crude tit-for-tat trade. It's only through a (very slowly) emerging rationalisation of the economic impact of aviation and of passenger convenience that even sixth freedom airlines have been granted market access - despite their lack of that trading currency. More to the point, they were "granted" that right only because it became too difficult to prevent them from exercising it. That is disruption.

When implemented, this process is called liberalisation. Sometimes it is consensual like open skies agreements. These are fragile shoots and still essentially bilateral, remaining limited by the restrictive principles of ownership and control outlined above.

A few airlines from large countries have "owned" the passengers

International aviation policy has typically been dominated by a handful of O&D airlines controlling significant domestic market 'currency'. These airlines, with one exception, are now grimly seeking to hold onto that legacy. Today these translate to essentially three airlines in the United States (Delta, American and United) and three airline groups in Europe (IAG, Air France-KLM and Lufthansa). As we have seen over recent years, these airlines have dominated the regulatory conversation, albeit, with the exception of IAG, often swimming against the tide of change.

Increasingly and quite ironically they themselves have also placed heavy reliance operationally on sixth freedom traffic. As the dominant players, they have then sought to lay down fairness "rules" to protect their status in this area: that is that sixth freedom traffic can be acceptable, provided it does not account for the majority of passengers carried.

The fundamental currency rules remain intact. There are also regular allegations of unfair subsidy, an exotic accusation that is always questionable in an industry where protective government tweaks in regulation can deliver enormous commercial benefits, even if they are not directly financially underwritten.

Meanwhile, specialist sixth freedom operators have been more or less tolerated, but are still regarded in some ways as operating outside the primitive "currency" system - because in these terms they have no currency to play with. They are creatures of liberalisation and, to this extent, remain fragile flowers.

This softening of approach occurred as tourism authorities, and for example the European Commission, have intervened to encourage a more economy- and consumer-friendly attitude towards the operation of international air services.

CAPA-Newton's Regulatory "Law of counter-Disruption" The Level of Disruption = (level of innovation - level of inertia) Even if you don't remember anything from your school physics, Newton's third law of motion will probably sound familiar: "For every action, there is an equal and opposite reaction". Just sitting in your seat, the force you are exerting is equal to the reaction from your seat; stand up, and your feet meet the same response from the floor. That rule is more or less immutable, quantum physics aside. In short, it's not easy to change things. Every time there is an attempt at movement, there will be an equally large force trying to prevent it. Mostly this is reassuring. Whether mechanical or philosophical, strategic or organic, inertia is a potent force. Which introduces Newton's first law: "An object at rest stays at rest and an object in motion stays in motion with the same speed and in the same direction unless acted upon by an unbalanced force." Inertia is intensely powerful. So it needs a very powerful eruption to shake it from the status quo to something different. The more so when - as in the airline industry - there is a combination of regulation, governmental and human intervention, with multiple supply chain linkages. Aviation's status quo forces are enormous and, accordingly, the level of inertia is immense. This is an industry which in so many was "stays at rest". Hence, aside from technical advances, there is little to show in terms of disruption. A system, established in another era, still dominates the profile of international aviation. In so many ways it is unhelpful. It must change, but for now the ways aren't obvious.

China's - and Asia's - rise is forcing a re-evaluation of airline strategy

Changing the regulatory order of things is extremely complex, even assuming willing parties. Underpinning the transactional bilateral approach, the persistent role of "ownership and control" clauses in the myriad of bilateral agreements has dogged any prospect of substantial disruption.

Even the US, whose government (often against the wishes of its major airlines) for example has been among the most liberal in promoting open skies and has a highly restrictive foreign ownership regime for its domestic airlines. This is mostly union driven, often without a great deal of logical evidence.

But, as the world's economic axis shifts, airlines which wish to grow must engage in the Asian markets. Staying at home will confine expansion and lead progressively to global irrelevance.

US and other airlines need to go international if they are to prosper and grow, despite the inherently riskier environment. Most of the world's best known airline brands are predominantly international operators. The same is not true of the US, with its huge domestic market, on which its now-consolidated airlines have grown large. That must change.

That's why Warren Buffett has got it wrong again

Warren Buffett once swore off investing in the airline industry, calling it a "death trap" after an earlier foray into US Airways. We'll make a bold prediction - Warren Buffett has got it wrong again. By 2020 at the latest his US airline investments will all have started to unravel.

Mr Buffett, in Nov-2016 when taking a new stake in each of the biggest four airlines in the US, is banking on them continuing to make substantial profits in the long term because (1) they benefit from market concentration; and (2) there is concentration in their ownership, with a small number of hedge funds and others holding strong equity positions in each of the major carriers. (The DOJ is reportedly beginning to look at the impact of this now). The dilemma for the biggest US airlines is that for the time being they can coast along on domestic operations.

The problem with that strategy is that the US domestic market is mature, with slow growth; and entry by smaller players is only going to increase as the US majors' cost bases rise. The rapid increase in salaries in this "race to the top" must be alarming for finance officers. It can be acceptable if yields continue to climb - a corollary of market control - but if they are depressed, the shadow of post-1996 looms large.

So, in essence, if they want to escape this repeat of history and grow they must go international. Quite understandably, they want to do so with minimal risk. But growth and risk go hand-in-hand and while the closed JVs can offer market strength and some protection, they can never be watertight.

Despite strenuous efforts by unions and Delta and others, coupled with an inexcusable DoT/DoS inertia to prevent entry on the North Atlantic, those JVs are now being challenged by Norwegian International, WOW Air and others. Although the major airlines inside the JVs have the advantage of significant hub connectivity at each end of their routes, they suffer the disadvantage of having considerably higher costs than potential competitors. Even the Department of Justice is starting to reassess its wisdom in so freely handing out JV excemptions.

This is the great danger for airlines that rely on artificial barriers (including domestic exclusion) to survive and prosper. Take away that prop and competing in the challenging international market becomes a much more difficult proposition.

JVs and bilateral airline agreements have become vital

Joint venture and bilateral partnerships have become enormously important to the success - and even survival - of major airlines. Limited by ownership and control rules, airlines have constantly sought options to expand their global presence. The multilateral alliances have gone some way in that respect, but the intensification of international long haul competition has greatly enhanced the value of close bilateral ties.

It was only after Qantas bit the bullet and joined its major competitor on European routes, Emirates, that Qantas' fortunes improved. It enhanced Qantas' virtual access to a range of European cities and Emirates' presence in the Australian domestic market.

On the Pacific, there is some movement towards JVs, but at least for the present, immunised JVs with Chinese airlines are impossible. In the absence of an open skies agreement between the US and China (something that does not appear likely in the near future if incoming President Trump's threats of trade retaliation against Chinese are followed through), there can be no fully immunised JVs with Chinese airlines.

On a similar scale, the fact that Japan, despite having an open skies agreement with the US, has only two full service airlines - covering Star Alliance and oneworld - means that Delta is left without a potential joint venture partner. This has pushed Delta towards a closer relationship with fellow SkyTeam member Korean Air, as well as encouraging it to invest a small minority interest in China Eastern Airlines.

In short, it is in the rapidly growing Asian market that much of the future potential lies; but there is not a similar level of risk insurance as exists on the North Atlantic. The alternative is either to remain out of the market or to accept higher levels of risk than are usually consonant with the higher margins the US majors are now achieving in the US domestic market.

(There is one important feature in the context of the way Asia's flag carriers will evolve and their potential role as partners as China's influence grows. With the exception of the Japanese flag carriers, whose historic traffic flows have been more O&D, most of the region's better known airlines have been founded on sixth freedom operations.

These sixth freedom airlines, almost without exception, are now confronting what Cathay Pacific Airlines CEO Ivan Chu recently described as the "new normal". This was not intended as an indication that the future would become easier. It refers to the dilution of sixth freedom traffic as new direct services and other lower cost competitors create strains.)

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THE ANTI-TRUST IMMUNISED JOINT VENTURE Immunised JVs now exist in several markets, most notably the North Atlantic, where each of the three Branded Global Alliances has an elite group of airlines operating as one. But a problem with closed JVs is that they leak. If they generate yields above industry norms; if the airlines in the JV are not protected by the safe haven of operating the lowest costs, they become an automatic target. The North Atlantic JVs, with their mirror pricing, have become an easy target for lower cost operators. Norwegian has rapidly intervened, even against a concerted campaign by US pilot unions and Delta, profitably expanding across a variety of routes. JetBlue is now promising to enter the trans-Atlantic market with its "Mint" business product, outside the JVs and leveraging its lower cost base to deliver a more competitively priced attractive product. And LCCs like Iceland's WOW Air and Canada's WestJet have also been attracted to exploit what has now become an attractive - if slightly "more rational"- major market.

Two developments have progressively undermined the old bilateral norms, making disruption possible

Two other developments have now occurred, with the effect of undermining both the authority of the handful of O&D airlines and the sanctity of ownership and control restrictions. The importance of these developments cannot be understated. Over the next decade they will transform the way international aviation operates.

First of all, a new influence has appeared in the marketplace, with an abundance of "currency" at levels never previously imagined. China has emerged, and its outbound tourists are delivering massive economic benefits to every country in which they land. The magnitude (and sudden appearance) of China's currency asset is unprecedented. Until recently, China has not been a principal voice in the formulation of international policy. Instead it has been content to rely upon the historical constraints of the bilateral system, protecting its airlines as they achieve a level of international competitiveness.

As it stretches its wings in the aviation market, China's influence is growing rapidly.

Secondly, there have already been a number of incursions into the sanctity of ownership and control provisions. These include (1) the proliferation of cross-border JVs, which have been particularly functional in Southeast Asia as LCCs like AirAsia have sought to establish themselves across the region as Pan Asian airlines; and (2) the revival of significant minority shareholdings in foreign airlines. Etihad appears to have sparked this trend, which is now being elaborated a multiple ways.

Those who would resist the flow of change so as to protect the status quo have argued in many cases that although there may be visible compliance with the minority ownership provision of the bilateral clause, "effective control" has passed to the acquirer. Occasionally this would appear to be the case; would anybody seriously assume that Virgin Atlantic is entirely free to pursue whatever policy it wants, when Delta - one of the loudest voices supporting "fairness" - owns 49% of Virgin's equity?

Cross border equity acquisitions are chipping away at the old system

There is another aspect of cross-border acquisitions, in which Chinese airlines and investors are now actively acquiring cross-border shareholdings both in foreign airlines and in a range of tourism travel activities. These are expansive and global. They are often linked to the markets suited to Chinese economic interests and to tourism. While for the time being they can be either very long term investments or intended to help participate locally in the benefits that inbound tourism from China can deliver, they undoubtedly provide a platform for a time when they can evolve into something more approaching controlling shares.

It is not a large leap to combine these elements of Chinese companies' investment strategies and the powerful impact of China's aviation "currency" holdings. The scale of travellers delivering wealth locally will be unprecedented

That is to say, as soon as China wants to push the boundaries further on ownership and control restrictions, it will do so.

Then, just as the US and European airlines have dominated the agenda for so long, China will meet little opposition if and when it seeks to assume controlling interests in foreign airlines. And so the process of reshaping the nature of airline operations will change dramatically.

After all, the bilateral O&C provisions are permissive, not mandatory. It is within any state's power to accept, or not, an airline which does not comply with the regulatory standards.

THE AIRLINE INDUSTRY - HOW REGULATION HAS STRANGLED MANAGEMENT INNOVATION There can be nothing more certain th an that the century old airline industry is ripe for disruption. And that it will happen, perhaps catastrophically and perhaps in the next downturn. That it has not occurred more comprehensively already is due to a range of interlocking factors: it is nationalistic (and iconic); it is heavily regulated - from safety to commercial operations to consumer interests; it is entrenched in multiple supply chains, visible and virtual; it attracts high levels of capital investment, with major vested interests keen to retain the status quo; and, above all, it is largely lacking in the agility to think (or move) outside the box. The latter assertion is perhaps a little unfair. There are many extremely imaginative minds in the airline business (as well as many which are not), but the ability actually to move beyond certain limits is heavily constrained by a myriad of regulation and nationalistic inertia. No other industry of its size and scope is constrained by the inability to consolidate, or is excluded from operating within foreign countries. These restrictions impact more widely than their direct effects; they tend to strangle innovation. It is likely the sheer inertial impact of regulation that delayed the introduction of low cost carriers for so long. Restrictions on market entry internationally and the impact of market dominance in many domestic markets generate complacency and inaction; it is only the heat of competition that spurs innovation. How obvious is it in retrospect that flying an aircraft for more than eight hours a day could dramatically lower costs? This in an industry that is burdened by capital costs; yet increasing that utilisation by 50% reduces by one third the number of aircraft an airline needs to buy. Instead of needing 60 aircraft, it needs only 40 - a billion dollar saving. And then, instead of the LCC exploiting its cost margin to the full, it applies a strategy that stimulates further growth; there are many features of the low cost model that are inconsistent with the strategies often-complacent or union-confined incumbents. Prior to the spread of LCCs, the often heard logic was that improving yields was a much more effective way of generating profits than reducing costs; all it needed was more market "discipline". That is the sort of complacency bred by regulation and artificial barriers to entry. Certainly it is the margin that counts; but a common goal today is to strive to have the lowest, or near lowest, cost in the particular market.

This is Part 1 of a two part report, based on the feature "Disruption in the airline industry. It will happen sooner than we think" which appears in CAPA's Airline Leader journal Nov.Dec 2016

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1. "Creative Disruption", BAML Equity Strategy | Global 30 April 2015