How much more business transformation does the airline industry need to ensure a profitable future?
Good morning. It is a pleasure to be at this important forum. When I last addressed the members of Airports Council International (ACI) in November 2011, I was still relatively new to IATA. Today, having visited more than 50 countries over the past 23 months, I believe I can say that I am a seasoned veteran—or at least a well-traveled one!
We are meeting as we approach the anniversary of a very memorable day for our industry—the 100th anniversary of the birth of commercial aviation. On 1 Jan 1914 Tony Jannus piloted an aircraft from St. Petersburg to Tampa, Florida. That 23-minute trip with a single paying passenger was the first recorded commercial flight and an inauspicious beginning for an industry that would change the world.
Certainly no one watching the occasion from the St. Petersburg waterfront would have anticipated that within a century, airlines would transport more than 3 billion passengers annually—equivalent to around 44% of the Earth’s population. Nor that aviation, within the course of one lifetime, would go from being a high risk activity to a routine part of daily life. With one accident for every 5 million flights on Western-built jets in 2012, air is the safest way to travel the world ever has known.
And I doubt anyone would have imagined how aviation would transform global commerce. Today some 57 million jobs are supported by aviation worldwide and we make possible $2.2 trillion worth of economic activity while transporting $6.4 trillion in goods, a third of world trade.
Yet there is one thing that has not changed very much over the past century. Aviation is an enormously capital and labor intensive business that is intensely challenging across the business cycle. It is an industry that remains highly vulnerable to external events and shocks over which we have little to no control. And, because of these factors, throughout aviation’s history, airlines in all parts of the globe have struggled to generate a satisfactory return to shareholders over the long term.
Therefore, the theme of this speech: “How much more business transformation does the airline industry need to ensure a profitable future”—is particularly relevant. For if aviation is to match its record of accomplishment in its coming second century, we certainly must attract the capital sufficient to grow sustainably, so that we can continue to provide the global connectivity upon which economies depend, and provide acceptable returns to our shareholders.
But before we look to the future and where we need to go, let’s briefly look at where we are today.
Last week, I gave the traditional State of the Industry address to the 69th IATA Annual General Meeting (AGM) in Cape Town, South Africa. The situation will not surprise anyone in this room. Aviation is highly competitive and we are always skating on thin ice when it comes to profitability.
This year we expect airlines to earn a $12.7 billion net profit. I know that sounds like a lot—and it is certainly an improvement on the $7.6 billion we earned last year. But on $711 billion in revenues, that’s a 1.8% net profit margin. And to put that into further perspective, it means that we will earn a $4.00 profit per passenger carried, less than the price of a sandwich in many parts of the world.
If we look at our history, it’s surprising that airlines are in the black in current conditions. And it bears witness to the enormous business transformation that airlines are successfully continuing. GDP growth is expected to be 2.2%--barely above the 2% stall speed, below which the industry has traditionally been in the red. And we are expecting the oil price to average $108/barrel (Brent) this year—leading to a jet fuel price of $127.4/barrel. That means that the price of our largest cost item has increased 55% since 2006—or more than tripled if you look back ten years.
Intense competition means that fares have been unable fully to recoup these cost increases: Average fares are one-third lower than 20 years ago in real terms, adjusted for inflation.
As an industry, the only way we could have survived such a dramatic change in our operating environment is by thoroughly transforming ourselves, examining all aspects of our business for ways to become more efficient and to create more value for the passenger.
So where are the profits coming from?
The answer is better performance. First, airlines have controlled cost increases. Despite the increase in fuel costs, total unit cost increases have been kept to 23%. Individual airlines have restructured and re-engineered their businesses.
Airlines have also improved efficiency at an industry level. E-ticketing is a good example. Not only does it reduce the cost of each ticket issued, it has enabled a slew of innovation in passenger services. Passengers can now check in online or at self-service airport kiosks. And mobile boarding passes are now being delivered directly to smart phones—adding to passenger convenience and further reducing costs.
- The baggage improvement program contributed to a 50% reduction in the rate of mishandled bags between 2007 and 2012, giving passengers a better experience and saving airlines money and resources
- Airlines found new value streams. A study by IdeaWorks and Amadeus found that ancillary sales grew to 5% of revenues in 2012. In fact, we estimate that without the additional revenue from these ancillary products, revenues would have been $10 below cost on a per passenger basis in 2012. Including ancillary products, revenue per passenger exceeded cost by about $2.50. And, as I mentioned we expect that to increase to about $4 this year with ancillary revenues continuing to play a key role.
- Capacity is being used more efficiently. The industry load factor is at a record high of 80.3%, which is an increase of 10 percentage points over the past decade.
- Global alliances and consolidation have provided larger and better-integrated networks for our passengers.
These are just some of the changes making it possible for airlines to achieve profitability, however small. Many of these could only be achieved with the help of partners. Transforming the check-in experience, for example, could only be done with the cooperation of airports.
But we know that in order to be sustainable we have a lot more to do. Together with our partners the transformation continues. For example:
- E-Freight will modernize the air cargo industry
- Paperless Aircraft Operations—on the flight-deck, in the ops center, in the maintenance hangar--could bring to operations a similar level of efficiency that e-tickets have delivered for the commercial sphere
- The New Distribution Capability (NDC) initiative will modernize distribution by creating an open XML-based standard for data exchange between airlines and travel agents. This will enable air travelers to enjoy transparent access to all of an airline’s products and services regardless of where they shop. It will bring distribution fully into the age of the Internet
A License to Grow
Our ticket to sustainable profits also depends on having a license to grow. And that means meeting our environmental responsibilities. Our commitment is for a 1.5% improvement in fuel efficiency to 2020, carbon neutral growth from 2020 (CNG2020), and a 50% reduction in net carbon emissions in 2050 compared to 2005. We are the only industry to make such a commitment, which has been joined by our supply chain and infrastructure partners.
Last week at the AGM, IATA members achieved an historic agreement on CNG2020. Governments were looking to the industry for a signal on how to proceed with market-based measures post 2020. They are a critical gap-filler until technology, operations and infrastructure solutions are fully matured. The industry met the expectation of governments and agreed that a single measure—an offsetting scheme—would be simplest and easiest to implement. And we also agreed to principles on how the burden could be shared among fast growing and mature airlines. This was a major accomplishment.
Now the ball is in the court of governments. We will be strongly supporting their leadership as they seek a global agreement through the International Civil Aviation Organization (ICAO) at its Assembly later this year.
We must also rely on our partners to be as equally committed to achieving long-term sustainability for aviation with sufficient infrastructure. Airlines depend on airports, air navigation service providers (ANSPs) and ultimately governments to ensure sufficient infrastructure capacity is available at economically realistic prices.
Many governments understand that connectivity is a strategic economic driver—Singapore, China, Chile, the UAE, South Korea, and Hong Kong are examples. Elsewhere, the story is much less positive. Airlines must contend with governments that see aviation as a luxury item, or a cash cow, not as a vital catalyst for GDP growth and job creation. The attitude does not contribute to a mindset of thrift and efficiency among our infrastructure partners. And one threat to long term sustainability is the rising cost of airport and air navigation services:
- Between 2007-2011 infrastructure costs per passenger have risen 15%
- Consumer prices have risen just over 9% in that period so infrastructure costs rose sharply in real terms
- Infrastructure costs represented 13% of the cost of air transport for the customer in 2007.
The ‘bite’ had risen to 15% in 2011, the most recent year for which figures are available
This is shared among airports and ANSPs. On the ANSP side, the Single European Sky is the poster child for transformation not achieved. The European Commission understands the importance of SES—not least of which is a EUR 5 billion boost to European competitiveness. But states are dragging their feet owing to wrongly-perceived narrow national interests.
Yesterday the Commission released further proposals to unblock the process. It’s a step in the right direction; particularly with giving the Performance Review Scheme some teeth to determine and enforce targets. But we still don’t have timelines that reflect the urgency of the modernization that needs to take place.
Of course, when push comes to shove, governments do react. Air connectivity was held hostage to a partisan political battle in the US when federal sequestration resulted in controller furloughs. Significant delays and disruptions followed. In less than a week Washington realized its mistake—unfortunately only after consumers and commerce paid a high price in lost productivity. Let’s hope that the US government remembers the importance of its partnership with aviation and rejects the $5.5 billion in new taxes on aviation proposed for the 2014 fiscal year. Burdening aviation with even more costs that have to be absorbed by air travelers and shippers is exactly the wrong approach to getting the world’s largest economy flying again and it will certainly not help ensure a profitable future for this industry.
We are all partners in this business, but I am sure you are more interested in our views on airports. Airports are airlines’ closest partners. Neither of us could exist without the other. Recognizing this, the re-organization that we are undergoing at IATA will improve the way we serve the interests of both our airline members and airport partners. From 1 July we will have a new division—Airports, Passenger and Cargo Services or APCS. And it will focus on the areas where airlines and airports connect. From Simplifying the Business and e-freight to costs, security and ground handling, APCS will take a comprehensive approach to the critical airline-airport relationship.
I would like to highlight two aspects of that today—capacity and cost. Airports are built to facilitate connecting communities to the global network. But an airline’s ability to take advantage of that opportunity is determined by the level of expense we must incur to serve the airport, measured against the revenue we can generate. So it is fitting that I spend some time discussing how we can become even better partners.
Historically, aviation has grown at around 5% per annum. In order to accommodate future demand, airlines are investing trillions of dollars in new aircraft. Infrastructure must be able to support this increase in demand as well. Indeed, the “Challenges of Growth” study by Eurocontrol to which IATA provided input, has cautioned that one million European flights annually cannot be accommodated on the ground by 2035 even under the most optimistic mitigation scenarios. That’s based on the actual and future airport plans in Europe. So meeting future demand is no simple challenge, particularly given the cost pressure airlines are under.
Airports are also under cost pressure. ACI reports that 70% of airports do not make money. And the average return on invested capital was just 6%, according to a study by McKinsey & Company. As with airlines, this is just below the sector’s 6-8% cost of capital. So neither partner needs poorly-thought out and overly expensive infrastructure development. To avoid this, we must work together in a collaborative process based upon the basic principles laid down by ICAO: consultation, transparency, cost-based charges, and no pre-financing of future infrastructure.
These are the principles, but we do not always achieve 100% alignment. More recently we have seen some studies purporting to show that these ICAO principles are out of touch with the times and no longer necessary. This is based largely on the claim that airports are now competing with one another on a regular basis, and that this competition imposes market discipline on airport charges. From this arises the argument that airports need more freedom to act unilaterally, to make decisions about levels of infrastructure investment and to have the freedom to decide which charging regime to follow and to be able to pre-finance future development.
Admittedly this is still very much a minority view, as demonstrated by the skeptical response to these theories by delegates at the sixth ICAO Worldwide Air Transport Conference (in Montreal earlier this year. Decades of practical experience and longstanding and credible economic theory have shown that most airports have substantial market power, and it is wishful thinking to believe otherwise. Even when alternative airports exist within reasonable proximity to one another, it is never desirable for an airline to divide its operations. Therefore, strong independent regulation is required to provide the cost discipline that otherwise would be imposed by the free market. And current international regulations offer sufficient flexibility for regulators to apply various levels of economic oversight where market forces do exist.
And to take this beyond a theoretical argument, London’s Heathrow airport provides an unfortunate example. My members would be very disappointed in me if I didn’t discuss it with you today.
We are working closely with Heathrow on many fronts with a joint focus on making the passenger’s experience even better. In fact, Heathrow’s latest tag line is “Making Every Journey Better.” This has not translated into the regulatory review of Heathrow pricing for the next five years. The UK Civil Aviation Authority has an expanded mandate to protect the interests of passengers. With that in mind, their regulator is challenging Heathrow to find efficiencies that will result in a pricing path that is 1.3% below inflation. Airlines have identified potential efficiencies that would be significantly below this. So, while the regulator is setting a precedent that efficiencies should drive costs down, we believe that the recommendation is not anywhere near as ambitious as it could be.
None-the-less, Heathrow’s response has been to suggest reductions in capital expenditure to the detriment of passenger convenience and operational resilience. I do believe that the airline-airport relationship has evolved significantly for the better over the years. And there is a growing list of airports that I would say are fantastic partners. But there are some big exceptions.
A Unified Agenda
While we have to be vocal on issues such as Heathrow—let’s not allow them to dominate the agenda. Nor should they undo much of the goodwill we have achieved in the past few years by working together to address our common concerns. Instead, I would like to propose creating a focused and unified agenda for air transport. This agenda would be based on:
- A mutual understanding that long-term sustainability is an issue for both airlines and airports.
- Recognition that the solution to our common challenge is not to take each other in an Anaconda-like grip to squeeze out every last penny from one another.
- Partnership and working together to help airports find new and mutually beneficial efficiencies.
We are already doing a lot together in safety and security – for example:
- Two key airport safety initiatives are the result of close collaboration between IATA, ACI and others: the Runway Excursion Risk Reduction Toolkit and the IATA Safety Audit for Ground Operations (ISAGO)
- And Heathrow, Geneva and Schiphol helped us to test component parts for Checkpoint of the Future, the first versions of which will roll-out in 2014
I believe that there is scope for further collaboration on Simplifying the Business—particularly in the universal availability of Wi-Fi in airports which would enable process improvements and new value-added commercial activities. There should also be scope for joint business development.
Our successful work on the environment attests to what we can achieve with a unified agenda. We should look for other areas to join forces. For example, we could campaign together to help governments understand the importance of harmonized passenger rights regimes, the ratification of the Montreal Convention 1999 to enable e-freight, and to fight tax proposals that would limit aviation’s economic contribution and stimulus.
We would also seek to remove capacity constraints. Nowhere is the problem more severe than in Europe, where 98 airports require slot coordination. The Worldwide Slot Guidelines provide an accepted way of dealing with the problem but by themselves they can’t resolve it. Rationing capacity is never a good thing, so we should also agree to look closely to determine whether there are alternatives available at some airports.
An agenda of cooperation does not mean that we will agree in every specific instance. But it does mean that we recognize we will achieve far more together than each could on our own. The issue of climate change is a good example of how we’ve found common ground and demonstrated leadership. This has also been true in safety, where we are natural partners.
During my two years leading IATA I have used the many opportunities to engage with aviation stakeholders to emphasize the importance of partnerships and working together. This is not just to ensure airlines have a profitable future but to lay the groundwork so that aviation can meet the demand for its products in our second century.
You asked me to address how much transformation the airline industry needs to generate sustainable profits. As any businessperson knows, transformation is constant. The minute you think you have achieved stability it’s time to start thinking of next steps. And this is true for partnerships—like the one between airports and airlines. There is still tremendous scope for transformation that will make the partnership stronger and benefit both travelers and economies with more efficient connectivity.
As we celebrate 100 years of commercial flight we can be proud that our industry is a force for good in the world. We re-unite friends and families; connect goods to markets; bring people to business; and create opportunities for understanding across cultures. To fulfill this important mission, the mindset of airlines and all the partners in the aviation business must be on transformation. It is only by working together that we will continue to develop aviation to be sustainable and ever safer, more secure and profitable.