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By Michael Zea
Airlines in today’s environment of economic uncertainty are doing everything possible to reduce costs and conserve cash. While this is understandable, a broader view may be necessary to reduce the risk of failure in both the shortand long-term. While the lingering effects of September 11 have certainly worsened the situation for airlines, even prior to this date airlines were five times more likely to lose a quarter of their value in one month than the Fortune 1000 average (Exhibit 1). What is more, historically most of these types of losses were not recovered relative to the rest of the airline sector.
Exhibit 1 The Risk of Value Loss for Airlines
Growth in Stock Price Relative to Growth in Industry (Indexed percent change in stock price: 1991-2001) 160 140 120 100 80 60 40 20 0 0 2 4 6 8 10 12 14 16 18 20 22 24 Months after Initial Drop
1Data was not available for all companies for all 24 months after the stock drop (e.g., for stock drops in the last two years). Where data was not available, companies were excluded. Source: Compustat, Mercer analysis.
S&P 500 Index S&P 500 Airline Index Nine airline companies suffering drops1
Some of the risk faced by airlines stems from a flawed and complex industry structure, which becomes more obvious when times are difficult. For example, ownership restrictions have prevented airlines from consolidating, which could mitigate local and regional economic risk. Also, the airline business model is capital, labor, and technology intensive, increasing the complexity of the risk management challenge. Much of this risk, however, could be identified and managed. The present lack of effective risk management strategies at many airlines has a clear downside: volatile earnings. In general, the financial markets do not trust airlines’ earnings consistency and, therefore, heavily discount the sector’s stock. Airline P/E ratios are generally half or a third of the market average, a fact often lamented by airline CEO’s. Airlines that have shown consistent earnings have been rewarded with faster stock price growth. For example, Lufthansa’s earnings have been half as volatile
21 Mercer on Travel and Transport
Individual risks and their impacts should be evaluated on a portfolio basis to understand and appreciate correlations among risks.g.. setting up Aeroplan as an independent loyalty business). strikes) Major IROPs Hazard Risks Terrorism/sabotage Weather Operational Risks One concept that can address this opportunity is “Enterprise Risk Management. and fuel prices. The primary risks facing the industry fall into four categories—hazard. and its stock price has grown twice as fast. Risk management is an ongoing process. quantifying their impacts. Exhibit 2 Airline Risk Factors Externally Driven Accounting/tax law changes Interest rate fluctuations Market share battles Customer demand falloff Pricing shifts (fare wars) Corporate culture Nontraditional competitors Alliances/ codesharing troubles Financial Risks Fuel prices Credit default Aircraft acquisition Strategic Risks Currency/foreign exchange fluctuations Asset valuation Financial market risks Recession Liquidity/ cash Internally Driven Revenue management Ineffective planning Unplanned or capital Customer expenditure overrun defections to competitors Union CRM attack disagreements Consolidation/mergers Key manager planning Maintenance/ reliability Scheduling risks Government intervention/ regulation Supply chain equipment issues E-commerce Credit rating 3rd party liability General liability/ legal risks Safety Cargo losses Inquiries Deductibles Property/aircraft damage IS failure/obsolescence Political risks Workers compensation Accounting/ control systems Network constraints 3rd party supply failure Business interruption (e. such as the protection of physical assets.. Some of these approaches have been successful. Air Canada now seems to be taking a page from Lufthansa’s strategic playbook by diversifying into airline-related services (e. interest rates. and developing and implementing integrated risk management solutions that align people. strategic. financial. There has also been some experimentation with hedging financial risks. not a one-time event. processes. such as foreign currency exchange rates. ! ! 22 Mercer on Travel and Transport . In general.g. but more aggressive techniques and a wider perspective would greatly increase the benefits. and technology to maximize enterprise value. and significant attention of late has been given to safety and security issues. and operational (Exhibit 2). airline risk management has been limited to hazard risk. Some tenets of this approach include: ! Not all risks are material—it depends on their potential impact on the value of the enterprise.as Air Canada’s during the past 10 years.” a process of systematically and comprehensively identifying all critical risks.
shifts in customer preference. Strategic and financial risks were much more prevalent. and war. accounting for nearly three-fourths of value loss events during the period (Exhibit 3). Financial 22% Operational 18% Hazard 11% Key Risks for Airlines Strategic risks are defined by business design choices and how these interact with various external factors. This was a long enough period to capture the full range of the economic cycle. It is also not subject to the tremendous reliability 23 Mercer on Travel and Transport . developing a rigorous strategic planning process. and industry consolidation are all strategic risks. such as creating a culture focused on the customer. liability. A challenge from a new form of competition. were the least likely to result in value loss. For example. or maintaining an independent board of directors. But many risks can be lessened in the first place through the selection of the business design itself. Southwest has designed a business that attracts customers in good times and in bad because it is simple operationally and. rather than focusing on the impact of one-time events such as September 11th. Overall. including the recession of the early 1990’s. Exhibit 3 Risk Events Precipitating Stock Drops. therefore. Interestingly. 1991-2001 10 8 8 8 6 Number of events 4 3 2 1 2 2 1 2 1 1 1 3 5 5 2 0 Competitive pressure Customer demand shortfall Alliances Foreign macroeconomic Interest rate fluctuation Cost overrun Safety War Merger New business misadventure Recession Fuel Labor Network risks Liability Strategic 49% Source: Mercer analysis. cost effective. hazard events.Mercer recently analyzed aviation industry risks for the 10-year period from April 1991 to April 2001. failure to manage the entire spectrum of risks resulted in the evaporation of $46 billion in shareholder value during this time period. Many of these challenges may be mitigated through traditional responses. including safety.
Lufthansa Cargo. all the while incurring system delays. Operational risks arise from the more tactical aspects of running the business day-to-day. Lufthansa Service. such as crew scheduling. derivatives. derivative markets. credit specialists. Revenue growth has been highest in the service-related divisions. general economic conditions or foreign exchange rates). and debt/equity offerings. Financial risks involve the management of capital and cash. For example. and e-commerce activities. Then strategies can be defined to mitigate risk wherever it resides. little effort has been put into working with the government to shape industry regulation or solve capacity issues. as highlighted in a recent Mercer study (see the article Low-Cost Airlines Gaining Momentum in Europe in this issue). and Lufthansa Systems. as well as evaluating each potential response through the lens of impact on shareholder value. contingent financing. which could push thinking even further in this area. down from 70 percent in 1995. for example.g. organization structural changes. contingency planning. Many airlines have processes in place to mitigate the most obvious operational risks (e. use of secondary airports insulates Southwest from direct competitive pressure while improving turnaround speed. improved communication. Other Southwest business design choices further lower risk exposure. techniques to mitigate financial risks are the most advanced.. but fail to address more subtle risks. Operational risks can be mitigated through organizational solutions. for example. insurance. and involves looking at risks holistically. primarily because there is a large third-party market dedicated to the effort (banks. Outside of hazard risks. The program began in 1994 after three years of losses. Low debt levels make the company less vulnerable to interest rate fluctuations. Lufthansa has pursued a strategy of business design diversification to reduce the volatility of their earnings base originating from the passenger airline business. And profit sharing and a fun culture reduce the chance of labor difficulties. with four companies being created: Lufthansa Technik. yet airlines have spent tens of millions of dollars fighting inquiries and lawsuits. however.g. and capital allocation and pricing. structured finance.). and threatening major network airlines on the Continent. process redesign.problems that bedevil network airlines. including exogenous factors that affect the variability and predictability of revenue and cash flow (e. While Lufthansa is 24 Mercer on Travel and Transport . business interruption and IROPS). as outlined in one of the examples below. Most managers would think of mitigating risks such as these as just part of “doing their job. etc. including. For example. There are other new approaches. Financial solutions may include the design and placement of financial transactions. and passenger airline revenues now account for only 56 percent of the total. accounting and information systems. performance measurement and reward systems.. Southwest’s success is now being emulated in Europe. Case Examples Mitigating Strategic Risk As mentioned earlier.” The challenge is great.
during the Asian financial crisis. despite the fact that not all of the divisions have been successful. Low-cost airline Ryanair recently placed an order for 100 Boeing 737s with 50 options. Some airlines have contained strategic risk through aggressive cash management. the only value left in the company after the recent liquidity crisis was in the services businesses.still reliant on the air transport sector.5 Southwest Singapore Airlines Delta AMR Northwest Qantas UAL Air Canada British Airways US Airways TWA Lufthansa Cathay Pacific Continental Source: Mercer analysis. upgrade products and services.0 1. Mitigating Financial Risk Hedging is a common way to manage the financial risk of input price changes. As a result. when fuel prices rise dramatically. however. Not surprisingly.5 0 -0. Exhibit 4 Operating Income Effect of Fuel Hedging 2. conserve cash during the boom times and invest in the trough. during a time when most airlines are deferring orders and mothballing aircraft. further entrenching their leadership position during the later economic upturn. also attempted to diversify geographically (within Europe) by investing in weak. If such tools are not further leveraged. second-tier airlines. Most airlines accelerate spending during periods of high growth to acquire new aircraft. and shareholders will suffer value loss during volatile periods of supply. For example.5 2000 EBIT per ASM 1. and maintain labor peace. airlines cannot pass all of the cost on to their customers.5 Operating profit before fuel effects Operating profit increase due to fuel hedging Loss in operating profit due to fuel price increase 2. While many airlines were able to maintain profits in the face of price increases. 25 Mercer on Travel and Transport . Airlines with the highest multiples. and are poised to further exploit the current weakness of Europe’s network airlines. it will be a level playing field. it is in a better position to reduce earnings volatility than its competitors. and no airline input is more volatile than fuel. more aggressive strategies could have been used to further improve results. unfortunately. Airline executives often comment that hedging is not a core competency. Unfortunately. they were able to negotiate a low unit price. and that as long as competitors are not hedged. Singapore Airlines initiated hundreds of millions of dollars worth of upgrades to their onboard product. As shown in Exhibit 4. earnings will continue to be vulnerable.0 (¢) 0. Mercer analyzed the effect of year 2000 hedging strategies among major airlines. Swissair pursued a similar strategy but.
the bank processing a weakened airline’s credit card transactions will put all of the funds into an escrow account. eight events could have been mitigated through improved merger integration planning and improved execution. a lump sum equal to the guarantee amount Of the 45 risk events analyzed by Mercer. nearly two-thirds could have been avoided using the types of approaches discussed above. the only alternative to risk management is crisis management. The impact of one-time value-destroying events and related earnings volatility would be reduced. Ten could have been mitigated through traditional means such as insurance or financial derivatives. to be released as customers use their tickets. 26 Mercer on Travel and Transport .” Phil Bolt. The risk analysis carried out by the guarantor focuses on the likelihood that the airline will fail to discharge its obligations rather than simply its risk of default. “leaders recognize that over the long-term. from the escrow account. In summary. This product. credit card escrow funds).’s London office specializing in risk services for airlines. developed by MMC Enterprise Risk.An example of a new technique for financial risk management involves guarantees for credit card transactions. given the many new tools available.g. This protects the bank against refund requirements should the airline cease operations. former Chief Risk Officer of Fidelity Investments and GE has said. a Managing Director at Marsh Ltd. This arrangement offers the airline access to additional funds at a lower than average cost of borrowing. Exhibit 5 Financial Risk Management: Credit Card Guarantees Credit card payments Customers Refunds Bank Refunds Funds released as customers use tickets Guarantor Airline Payments Escrow Account Guarantor provides financial guarantee to bank Airline receives. a guarantor “insures” the refunds to the bank. Fourteen events could have been mitigated by more consistent and in-depth customer analysis. allows an airline to access otherwise unavailable cash (e. As James Lam. shown in Exhibit 5.. Insurance capacity can typically provide a flexible risk mitigation avenue. and shareholder value dramatically improved. which then releases the cash in the escrow account. also contributed to this article. without exposing the insurer to undue risk of losses. combined with scenario planning and game theory exercises. at a time when traditional funding lines are strained due to the industry’s weakened financial state. Normally. In the new arrangement. it is time for airlines to move to the next level of sophistication in Enterprise Risk Management. Finally.
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