The Recent Changes In The Airline Industry

Published Date: 02 Nov 2017

In his article "The Five Competitive Forces That Shape Strategy", Michael Porter states that the airline industry is one of the least profitable industries [1] . By going through his chart it is very easy to observe why. The nature of the competition is very intense making it very difficult to attract and keep passengers. Customers in this industry are price sensitive. The low entry barrier allows other companies to enter the industry fairly easy increasing competition. The high dependency on oil prices, human capital and government regulations, which also play also a vital role in this industry, make it difficult to play with margins.

The airline industry faced some changes in recent years. Responsible for these changes are mostly the volatile fuel prices, government policy, the overall economic wellbeing as well as the strategy of the airlines. For example, the average price of the kerosene barrel peaked in 2011 to about $127,5, above the high annual average 2008 of $126,7 [2] . This has a direct impact on the fixed costs of airlines in the entire industry. According to the International Air Travel Association (IATA), fuel represented in the year 2000 15% of the total airline operating cost. Nowadays it accounts for more than ¼ of their total operating costs, an increase of more than 10% [3] . All the other costs remained roughly stable throughout the years with the exception of the distribution channel costs, which have fallen in time.

The airline industry has been highly regulated by governments after the Second World War. In the past 30 years regional trends regarding the regulatory policy emerged. In most of the world, privatization and liberalization or deregulation are the main driving trends. This in turn favored the rapid growth of the number of airline. To be more specific, in the past 40 years over 1300 airlines emerged, resulting thus in an increase in competition. Government regulations aren’t the only force favoring the appearance of new airlines. The worldwide rising demand for air transport and fright is another sustaining force.

On the other hand, some control has to be imposed by the governments, like security control or air traffic control. Notably is the fact that air traffic control costs are roughly twice as high in Europe as they are in the US. Even though these extra operating costs are normally financed by airlines through administrative fees, this puts serious burdens on European airlines and alters their competitiveness. Other examples are the overnight operating ban imposed on the Frankfurt am Main airport or the so called "Luftverkehrsteuer" which directly affects the business strategy of airlines.

Looking at the data from 2007 until now a shift can be observed in the worldwide economic growth. China, India and Latin America average for the most rapid economic growth in the world. It seems that the US and Europe are being left behind. The global economy is shaped by globalization and high volatility. This means that today’s profitable markets may be unattractive tomorrow and vice versa. Following this presumption we can infer that past strong European and US networks are declining while the entrance of Asian companies on the market is intensifying the local as well as the global competition. As a matter of fact, the Asian-Pacific region is the most profitable to date. Asian companies are not the only ones who put pressure on the European legacy carriers. Low Cost Carriers (LLC) in Europe are also burdening the big European airlines. One possible solution for the legacy European carriers is to rethink their business model towards international markets.

An interesting observation is that the worldwide demand for premium seats rose above that of economy seats after the recession in 2008 [4] . In Europe however, the trend is the other way around. The demand for economy seats is higher. An argument would be the somewhat shorter flying distances and the lack of comfort needed for this short flying period. On one hand, this favors the further development of the LLC’s while on the other hand has a direct effect on the profitability of legacy carriers. As stated in the introduction, the customers in this industry are price sensitive.

European airlines try to face these turbulent times mostly by cutting costs, restructuring or merging operations. Lufthansa, Europe’s biggest airline and a founding member of Star Alliance, is also facing tough times. Rising oil prices, aging fleet, strike of the employees, the overnight flying ban at Frankfurt airport, strong competition from LCC’s and many more put a strain on Lufthansa’s recent performance. Revenue grew steadily since 2009 but operating profit dropped about 50% in the past three years.

Lufthansa’s business model focuses on three core competences: passenger air travel, freight transport and services, which the last comprise of IT services, catering and technology [5] . The main profit generators are its airline companies. Through the SCORE (an acronym for Synergies, Costs, Organization, Revenue and Execution) program Lufthansa is aiming for increased productivity and efficiency necessary for long term along with an correction of the operative profit of 1,5 billion Euros. This strategy involves administrative changes as well, which will be discussed further on.

To face the assault of the LCC’s, especially Easyjet and Ryanair, Lufthansa is investing to improve the competitiveness of its own LLC, Germanwings. According to its annual report, Germanwings will overtake responsibility for all flights in the home country and most parts of Europe beginning with 2013. Through this strategy, Lufthansa aims for increasing its competitive advantage against European airlines and lower costs at the same time. This strategic decision is also part of the SCORE program. The now unprofitable subsidiary Germanwings should bring positive results by 2015.

As stated above, in Europe, the demand for economy seats exceeds that for premium seats. The business model of Germanwings will not be that of a traditional LCC. According to Lufthansa’s annual report, German wings will provide future passengers three different economy fares [6] . The first one is directed towards customers, who prefer to fly very cheap without further services, the second is directed towards low-price and decent services oriented customers and the last offer is dedicated for business clients. The outcome of this strategy and the new business model will turn Germanwings into Germany’s third largest airline. Furthermore, 90 airplanes and additional staff will be transferred from Lufthansa to its subsidiary. By the end of 2015, Germanwings should be serving 16 million passengers [7] yearly bringing about 200 Million Euros profit to the concern.

This strategy is also one of the main reasons why many employees are striking lately. According Lufthansa’s CEO Christoph Franz, about 1000 cabin crew members and 300 pilots are to change companies from the parent company to its subsidiary. This presumes an adjustment in their salary as well, many of them falling up to 40%. In the airline industry, labor plays a huge role. If the pilots are on a strike and aren’t flying, the company doesn’t make money. Even worse, in most of the cases, due to recent regulation in the EU airline policy, the company has to compensate these delays resulting in huge losses. This in turn can have a negative effect on the concerns image.

Lufthansa will remain a premium carrier and will focus its business on long haul passenger flights. Its main focus is to strengthen the positions in US and Japan. The two existing North-Atlantic Joint-Ventures with United Airlines and Air Canada will be further developed. Additionally a third Join-Venture with All Nippon Airways commenced on the 1st of April 2012. With rapidly growing demand for air transport in Asia, this JV could bring benefit the business situation of Lufthansa. Further potential on the Asian market can be exploited thanks to the entrance of the Chinese Shenzhen Airlines and the planned one of the Taiwanese Eva Air. Air France-KLM, British Airways / Iberia, US carriers like Delta Airlines and American Airlines as well as local carriers are posing a threat as the competition from Emirates, Qatar Airways and Etihad Airways for market shares is fierce. Currently, about 19% of the total flights are directed towards Asia whereas about 67% serve for air travel between US and Europe and within Europe.

Another goal in the SCORE program is to reduce costs with fuel. With continually rising and all time high oil prices as well as harsh EU regulations regarding emissions, investing in new fuel-efficient airplanes is definitely a sound strategy. Trimming down 1% of the total expenditures on kerosene will result in saving roughly 74 Million Euros yearly. This will not only bring value to the shareholders, but it will also attract the sympathy of eco-friendly political supporters. The EU-Commission is planning to toughen the carbon dioxide emission taxes, making airlines buy more certificates if they emit more CO2 then the EU allows. This in turn will lead to higher ticket prices. Investing in fuel-efficient airplanes could also be benefit Lufthansa’s competitiveness. (p40 in GB)

At the Frankfurt am Main airport another runways is currently being built to meet the high demand. The success of this project is of high importance for the air travel in Germany. On the 29th of Mai 2012 however, the Federal Administrative Court of Hessen imposed the overnight operating ban. This decision affects both passenger and freight transport regardless the airline. With one of its main hubs in Frankfurt, Lufthansa Cargo was especially hit by this decision. According to the company, the ban leads to about 40 Million Euros in losses each year. Nonetheless the company is committed to expand the Logistics Center at the Frankfurt airport. Freight transport has also been seriously affected by recent changes in the worldwide economy. China, India, The Middle East and South America are enjoying fast economic growth, while the US and Europe Governments fight against recession, high sovereign debt and financial crisis. However, Lufthansa Cargo managed to write positive results. About 50% of the total freight revenue comes from Asia and the Middle East while the other 50% is being generated in America and Europe, mostly in America [8] .

The entire airline industry is facing tough times at the moment. Whether Government policy, oil prices, overall economic growth or future trends, they all shape the strategy of the airline companies. In this strong cyclical business, Europe is currently facing the biggest turbulences. With about 80% of its total revenue generated in Europe and America, the core of Lufthansa’s business, passenger air travel, has registered negative results. The fall in numbers was sustained by the income rendered from the other activities of the concern, namely freight transport and services. Restructuration and cost cutting are driving employees into organized union strikes resulting in further losses.

To counter these threats, Lufthansa developed the SCORE strategy and plans to extend further cooperation and Joint-Ventures. Whether it will be able to leverage exploiting market shares in the new emerging economies and develop a sustainable growth will be observed in the next couple of years.

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