Key features of air transport markets - Brian Pearce – IATA - June 2014 OECD discussion on airline...

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Some key features of air transport markets Brian Pearce Chief Economist June 2014 www.iata.org/economics

http://www.iata.org/economics

City-pairs doubled – transport costs halved

IATA Economics www.iata.org/economics 2

Source: IATA, ICAO, OAG

0.5

1

1.5

2

2.5

3

3.5

4

-

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

1994 1997 2000 2003 2006 2009 2012

US$

/RTK

in 2

014U

S$

Num

ber o

f uni

que

city

-pai

rs

Unique city-pairs and real air transport costs

Unique city-pairs

Real air transport costs


Falling costs passed through to consumers


Source: IATA, ICAO

-

1.0

2.0

3.0

4.0

5.0

6.0

7.0

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

1950 1960 1970 1980 1990 2000 2010

US

$ in

201

3 pr

ices

per

tonn

e ki

lom

eter

US

$ in

201

3 pr

ices

to fl

y a

tonn

e ki

lom

eter

Unit cost and the price of air transport

Price(US$/RTK)

Unit cost(US$/ATK)

US deregulation

EU deregulation

Boeing 707

1973 oil crisis


Consumer demand extremely strong


0

50

100

150

200

250

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Inde

xed

to e

qual

1 in

195

0

World scheduled air travel, freight and world real GDP

Air travel(RPK)212x

GDP (constant prices)10x

Air cargo(FTK)212x

Source: IATA, ICAO, Haver


Profit margins extremely low


Source: IATA, ICAO

-6%

-4%

-2%

0%

2%

4%

6%

8%

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Airline industry profit margin, after debt interest and tax

Average0.2%


Investor returns below cost of capital


Source: IATA, McKinsey

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

10.0

1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

% o

f inv

este

d ca

pita

lReturn on capital invested in airlines

Cost of capital (WACC)

Return on capital (ROIC)


Why? • Value chain as a whole sustainable?

– Market power in parts of chain/ over-regulation elsewhere?

• Excess capacity? – Imperfect capital markets?

• Common and joint costs? – Hard to recover?

• Empty core? – Financially sustainable equilibrium not possible?



Much of air transport value chain is profitable



0

5

10

15

20

25

30Return on invested capital in the air transport value chain, 2002-2009

ROIC WACC


But dwarfed by sub-normal airline returns


-25

-20

-15

-10

-5

0

Investor returns in excess of cost of capital, $ billion a year



Easy and regular new entry


Source: IATA, Ascend


But also significant failure, exit and merger


Planet

duo

nexus

Air Wales

Thomsonfly Nordicairlink

flyforbeans.com

clickair

Atlas-blue

myair

flyglobespan

GoDebonair

mytravellite

dba

Basiqair

jetmagic

Iceland Express

AerArannAerlingus

Ryanair

MonarcheasyJetflybe Transavia

germanwingsairberlin

WIZZ

Voloteavueling

SkyExpress

Norwegian

Pegasus

Jet2

snowflake

flyeco Skyeurope

Hamburg airlines

Helvetic

VBIRDVirginExpressEUjet

FlyMe

buzz

Volareweb

Maersk Air

Air FinlandFlying Finn

KissGetJet

Aeris

Smart Wings

centralwings

fly gibraltar

HLXLTU

Air polonia

flybaboo

flywest

VikingSterlingCimber

Air Turquoise

Germania

air lib express

Clickair

WindJet

WOW

Failed Survived

European ‘LCCs’

Source: HSBC


There are significant common & joint costs


Fuel, 33%

Passenger services, 8%

Airport & ANS, 7%

Maintenance, 10%

Station expenses, 9%

Ticketing, sales, promo, 8%

Flight crew salaries, 6%

Aircraft rentals, 6%

Depreciation, 5%

Overhead & other, 8%

Operating costs breakdown 2012

Source: IATA


Significant economies of scale in equipment


Segment distance (NM)

Aircraft type

Seats Segment cost (DOC)

Average cost per seat

Marginal cost per additional seat

500 ERJ-145 48 $6,934 $144

E-190 100 $10,794 $107 $74

1000 737-700 129 $20,039 $155

737-800 168 $23,875 $142 $98

2500 A319 132 $41,607 $315

A321 190 $51,462 $270 $169

Source: IATA


But business customers demand frequency


• Economies of scale in equipment incentivises: larger aircraft and fewer frequencies

• But strong preferences of business customers – who value their time highly – for: frequent (daily) services and specific departure times

• With free entry, unless very dense passenger flows, market outcome is: smaller aircraft and more frequencies

• What fare structure would emerge in such a market?


Price ‘segmentation’ economically efficient


• Two/multi-tier fare structure consistent with open competition • Preferences of business travellers prevent cost-saving larger

aircraft • Business travellers should pay premium for higher unit costs

imposed by more frequency • Premium reduced by larger aircraft made possible by attracting

more price-sensitive leisure travellers • It is also a mechanism for allocating common/joint costs

• This is an open competition outcome due to economies of scale, common/joint costs and preferences for frequency

• Non-core ‘ancillary’ services perform similar role • Cover common/fixed costs while core transport product is

offered at marginal cost – an economically efficient outcome • Similarly, different cuts of meat see price ‘discrimination’


Economies of density in route networks


• Minimal economies of scale in firm size • But substantial economies from density of traffic flows • Business models are different ‘factories’ generating ‘route density’

Source: Lufthansa


‘Metal-neutral’ airline JVs deliver efficiencies


• Few city-pairs can support frequent point-to-point services • ‘Hubs’ generate route density where necessary

• No single airline can provide ‘from anywhere to anywhere’ service demanded by business customers • Cross-border mergers mostly impossible • Airline innovation in response

• Interlining • Code shares • Alliances • JVs under ATI

• ‘Metal neutrality’ has been the successful development • Airline JV partners indifferent over who carries passenger • Generates efficiencies from increasing traffic density • Efficiencies lower with looser cooperation


As well as price/non-price consumer benefit


• Lower fares for interlining passengers (no double marginalization) • Lower fares from economies of traffic density

• Effect also can apply to overlapping hub-to-hub markets • Fares can be more easily combined in an itinerary • Passengers offered wider range of schedules • More seamless passenger experience


Summary


• Economic benefit from connecting cities and cutting transport costs • Air transport 7x cheaper than 6 decades ago • Demand has grown over 212x compared to a 10x rise in GDP • Airline net profits close to zero • Airline ROIC consistently < WACC • Some parts of value chain make returns > WACC • Easy and frequent new entry • Significant common and joint costs – hard to recover • Economies of scale in equipment • But business customers demand frequency • Open competition outcome is a segmented price structure • Economies of density important – business model ‘factories’ • JVs can deliver efficiencies as well as non-price consumer benefits


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