“Revival of a Sick Airline” INTRODUCTION Wild fluctuations in fuel costs, tightening corporate travel budgets and anxious consumers have created shockwaves through the airline industry. In the current environment, any activity that doesn‘t directly contribute to filling and operating flights safely and efficiently is under the microscope as carriers scramble to find ways to stem the tide of red ink. However, quality service and a positive customer experience is more important than ever for attracting and retaining passengers, especially for the most profitable customers: business travellers. Finding creative ways to improve service without adding costs—or better yet, reducing costs—should be a top priority for every airline. "Questions of control and viability" analyses the causes for the sickness of airlines and suggests remedies. Winds of change are blowing with liberalisation and globalization, but these airlines have learnt nothing. Their top-heavy managements have failed to anticipate problems and suggest timely remedies or are it possible that the political bosses have shot down all suggestions for the revival of the airline? While some public sector undertakings, such as the other companies, have proved profitable and able to stand on their own feet, HIND AIRLINE has been in the red and limping for years. It is the time civil aviation management, which is no fountain head of airline management expertise, took its hand off the airline. There is no alternative to disinvestment and participation of private parties who can provide the management skills to run the airline. As a temporary measure, international airline management consultants can be hired. The government can provide long-term loans to help the airline tide over the financial crunch and phase out the ageing aircraft and purchase state of the art ones. Research on the performance of major airlines suggests that there is a positive correlation between on-time performance and operating profit. This is a similar phenomenon to that found in manufacturing industry—where the cleanest factories tend to be those with the highest productivity. Poor On time performance Punctuality is a key leadership challenge throughout the organization and should rank high on the management agenda—from strategy and planning all the way to front-line operations. In rising to this challenge airlines need to take a strategic perspective and apply a comprehensive framework that addresses the three main levers for punctuality improvement that are within their reach: — Network planning and control — Aircraft availability — Ground operations and departure process Our research shows that major airlines with above average punctuality rates have been more profitable than those with lower than average punctuality performance. On top of the negative impact on customer satisfaction, delays are expensive. Direct and indirect delay costs typically range from 0.6% to 2.9% of revenue, depending on the size and type of operation and the method of calculation. This combination of significant revenue and cost-side effects is why punctuality should rank high on top-management‘s agenda. However, punctual airlines appear to be more profitable. Research shows that major airlines with above average punctuality rates have been more profitable than those with lower than average punctuality performance. Tools such as simulations, statistical sampling, process monitoring and key performance indicators build the foundation to drill down to the root causes of delays. The key success factor is to merge quantitative analytical rigor with the rich qualitative information from front line observations, know-how and staff experience. Two major trades-offs: Punctuality vs. cost and equipment utilization One of the most obvious and easy measures to increase punctuality is to remove bottlenecks and add capacity (e.g. the number of aircraft, longer block times, and more ground staff and equipment). Without a solid quantitative business case, based on analysing potential savings from avoided delay costs, it is unlikely that a controller will support such ideas, especially as most of the savings are variable while the capacity increase builds up fixed costs. Punctuality vs. turnover and yield Short-term revenue considerations such as display visibility in the global distribution systems (GDS) do in most cases work against punctuality. Maintaining slots at peak times during the day, short connecting times and tight block times are valid sales-based arguments. However, they may ultimately result in poor operational performance, and may therefore become counter-productive to revenue maximization in the long run. Identifying the „Real‟ Delay Root Causes There are three basic approaches to identify the ‗real‘ root causes of delays and to define improvement levers — “Conventional” methods — Process monitoring and sampling — Simulation Conventional Root Cause Analysis This category covers the conventional methods of analysis used in most airlines, for example, delay code frequency, fishbone diagrams and correlation analyses. In the initial stages, these methods can help identify the broad picture and provide a first cut understanding of the major problem areas. These methods also work well to generate agreement in cross-functional discussions and workshops, as they are easy to understand and based on the immediate experience of staff. Many airline executives distrust the delay codes reported by the front line. Nevertheless, they are helpful to highlight major problem areas. A pragmatic interpretation is that systematic failures in delay code allocation are at least consistent over time. Therefore, they can provide data on delay patterns that highlights short- and long-term trends in certain ―delay areas‖. To identify and understand the root causes it is necessary to leverage the knowledge of the staff. The people working every day in the key processes do know many of the root causes but this information is often not reported. Listening to them one by one may be frustrating, but their individual statements are like pieces in a jigsaw puzzle that reveal the true picture when put together. One thing that is often forgotten is to analyze the good days. There is an untapped resource of information, often neglected by solely focussing on a problem-oriented approach. Our experience is that it is important to study the perfect days on a regular basis to better understand the causes of delays. Process Monitoring and Sampling Process Monitoring and Sampling‖ establishes a database to evaluate process performance in the overall departure process, supplier processes, and the activities in problem areas. Process monitoring requires that key milestones in the departure process are defined and measured. Some airlines conduct spot checks on such milestones, taking samples from a number of flights on a regular basis; others go as far as using automated electronic time-stamps that feed into online monitoring systems. Although such systems can require significant investment, the increase in operational transparency will pay off Data from process monitoring allows the dissection of the departure process, identifies the origins of delays and the impact on the overall airline delay rate. The key success factors are analytic rigor and the use of a systematic top-down approach that continuously asks the question ―So what‘s the ‗real‘ root cause behind that apparent root cause that we need to remedy?‖ Simulation The Monte Carlo simulation of the rotation plan is a very powerful tool for evaluating and optimizing the schedule. Simulations are also useful to plan certain ground activities such as gate allocation. The expected outcomes of Monte Carlo simulations are: — The effect on punctuality of variations in isolated parameters such as block hours, slack distribution, etc. — The impact of external factors such as ATC delays — The identification of the critical lines of flight in the rotation plan—those lines that are most sensitive to poor execution Simulations will not tell how to solve executional problems, but they will put an end to some of the company‘s myths such as ―we cannot do anything to improve punctuality because all the problems are due to ATC‖. Solving the Delay Problems As soon as the root causes are visible and agreed on, the path to remedying them is usually clear and the different improvement options can be evaluated. These options typically fall into two categories— internal measures and supplier related measures Internal measures include: Resources, capacity and infrastructure. These refer to measures such as using dedicated resources for critical processes, reserve aircraft, or investments in system improvements. Process design and optimization aiming at doing things in innovative new ways, which have not been thought of or attempted before. Empowerment, motivation and discipline. These factors include incentives, new policies, clear roles and responsibilities for the staff involved. Supplier related measures include: Service level agreements, which address not only what to deliver but also when to deliver it. Operational planning and interface design, integrating the activities and processes of each supplier within the entire network of operations. Continuous monitoring and feedback as well as incentives and penalties which close the feedback loop in the supplier relationship and which assign clear ―consequences‖ to good or bad performance levels. Many attempts to improve on-time performance have focused on one area at a time, such as adding more slack to the schedule, decreasing turn-times, and not waiting for delayed connecting passengers. Unfortunately, an improvement in one area often creates pressure on another—like squeezing a balloon, the problem pops up elsewhere. Mercer has found that effectively improving on-time performance over the long-term requires a holistic approach that takes into consideration four key levers: planning, execution, recovery, and feedback Planning In building route structures and aircraft rotations, airlines seek to optimize the use of their expensive aircraft. They create schedules designed to maximize profit, based on forecasted demand. However, schedules are too infrequently checked for robustness, leave little slack for recovery in case of irregularities, and can build in impossibilities. Planning for superior on-time performance means building a flight schedule that is both reliable and robust enough to handle the unexpected. Maintenance and operations planning must be developed hand-in- hand with the flight schedule. A reliable schedule accurately reflects the environment likely to be faced on the day of operations. To build such a schedule, an airline needs to evaluate the fundamental elements of the schedule (block times and turn-times) and the impact of operational constraints that might be encountered during schedule execution. Frequently, airlines will use broad averages to forecast the time required for each flight. This ignores the large variations that can occur depending on the time of day, day of the week, other airlines‘ flight schedules, etc. For example, one airline found that airborne delays had significant peaks on Monday mornings and Thursday afternoons. Rather than increasing block times across the board, the airline was able to tweak the times for the affected flights and improve on-time performance while minimizing the revenue impact. While each airline‘s operational environment is unique, all systems have constraints on the amount of activity they can support. An airline can accidentally schedule its way into congestion and delays by scheduling more movements than the infrastructure can support. A quick way to identify this problem is to compare scheduled arrivals/departures to actual at a major hub, controlling for the effects of large-scale disruptions A hub‘s economic success is linked to its ability to generate numerous connection possibilities during a relatively short time frame, generally 60 minutes or less. When an airline cannot deliver on peak arrivals and departures, flights slip out of the connection zone and marginal revenue is lost, without a corresponding decrease in costs. Indeed, Mercer has found that costs increase. Thus, rather than operate late, an airline may need to reduce the number of movements while working to identify and eliminate the bottlenecks that limit its capacity. Execution Managing schedule execution is one of the greatest challenges in the business. Thousands of activities must come together seamlessly to keep a flight on time. To stay on schedule with such a complex operation, an airline must ensure superior management of the ―critical path,‖ i.e., that set of core activities which determines the actual length of the flight. An extra minute in any one of the critical path activities means an extra minute overall. The critical path of an airline flight has three segments: on the ground, in flight, and overnight. When the aircraft is on the ground, the critical path is the cabin. The time for passengers to disembark, for the cabin to be prepared, and for the next set of passengers to embark determines the amount of time the aircraft will be on the ground ―Under the wing‖ activities, such as fuelling, inspections, and loading baggage, are generally not considered to be part of the critical path, as these can be conducted in parallel, while the cabin activities are sequential. Recovery In spite of good planning and execution, delays will occur. Once this happens, the airline must go into recovery mode, not only to limit the impact on on-time performance, but more importantly, to limit the impact on the customer. Large-scale disruptions are the result of an important reduction in an airline‘s capacity. The most frequent cause is ATC authorities reducing the number of movements at a hub airport due to poor weather. The airline then has the choice of reducing the schedule to match the new capacity or delaying successive flights for the rest of the day (and then is often forced to cancel at the end of the day anyway because of curfews or crew service time violations). At large carriers, these knock-on effects can show up as increased delays over a period of several days. In most airlines, the biggest cause of delays after weather is the previous flight being delayed. With airlines under pressure to better utilize their aircraft, scheduled turn-times often do not leave slack to absorb late arriving aircraft. As a result, delays do not go away by themselves and must be attacked with an appropriate recovery solution. Operations managers, in cooperation with the other divisions, can reallocate resources to stop delays from building up, taking advantage of the recovery opportunities that have been built in during the planning process. The types of reallocation options—swapping aircraft, crew, or gates—are limited, but the process can still be very complex, given the large number of resources (as well as regulatory constraints) that must be taken into consideration. Feedback A holistic approach to on-time performance is not complete when the day‘s operations are finished. At most airlines, what actually happens on a given day can end up being quite different from what was planned. This isn‘t necessarily bad, but an airline can only improve its on-time performance by feeding information about schedule variances back into schedule development and operational planning. Otherwise, the airline will simply be doomed to experiencing the same schedule problems over and over again. Capturing information on delays and proposing solutions is only half the challenge, however. Where most airlines fall short is in applying an objective, rigorous analysis to proposed solutions. This requires a cross-functional team armed with appropriate techniques to develop a quantitative assessment. If a proposed solution cannot be summarized quantitatively and supported by a business case, an airline cannot determine the impacts of changing the planning process versus the potential gain in on-time performance. Without an objective and strong process owner, feedback turns into nothing more than anecdotal comments during schedule development meetings. Aging Fleet and Low Profitability Passenger-To-Freighter (P to F) Conversions and Aging Aircraft In October 1996 the FAA completed a Freighter Conversion STC Review of a cargo operator. This review revealed that the company involved was not completing the conversion to FAA satisfaction and that some of the engineering was drawn and described after work had started or even been completed. The review further revealed a significant lack of quality control. Several beams were unsupported or simply butted up and not fastened at all. It is commendable that this incomplete and dangerous work was discovered, while at the same time, it begs the question of what other shoddy effort has not been discovered but has been certified as complete and airworthy. Inspections of these modification facilities need to be more rigorous and at an increased schedule. In 1998 the FAA found that numerous B-727 converted aircraft were not in compliance with their STC. Sufficient engineering had not been completed to allow the higher weights to be carried in most positions on these aircraft. While it is good that the FAA discovered this problem and took action to bring these aircraft into compliance, it points out a potential weakness in the system that the situation developed in the first place, and that these aircraft flew for several years and were not airworthy. Floor strength is a major concern with a converted passenger-to-freighter (P to F) aircraft. The increased loads throughout the cabin are substantially higher with cargo then when passengers are carried. The weight in a zone or pallet position can be more than doubled based upon 18 passengers with seats of 22-inch pitch and carry-on baggage to be approximately 4,000 lbs. This same position on a cargo aircraft could be certified to carry more than 8,000 lbs. Aircraft have been found to have fuel tanks supported by the same floor beams that are carrying the main deck cargo load. In a FAA-published case, the combined floor weight and suspended fuel tanks with fuel would have exceeded the certified weight by 100% or twice the allowable weight. Due to structural modifications that add weight, freighter aircraft are usually operated at higher zero fuel and take-off weights than passenger aircraft of the same type. These increased weights result in increased speeds and air loads. Operating at these higher weights increases loads on the landing gear, flight controls, spars, brakes and engines. The higher reference speeds also result in more frequent operation near the flap and gear limiting airspeeds, thus the assumptions made during initial certification about exposure rates to high loads may not be valid. There is an on-going FAA Certification Process Study (CPS) to feed operational data back into the certification process. This effort and resultant recommendations may help to minimize this problem. These increased air loads have been responsible for several flap failures that have been close to loss-of-control events. With the quick expansion of the express cargo airlines in the late 1970s and through the 1980s, aircraft modification facilities expanded their business to include conversions of passenger planes into cargo aircraft. One of the major modifications was the addition of the main deck cargo door. It is widely known in the cargo industry that the best cargo door is the door that was incorporated in the manufacturing process, in other words, an original part of a new aircraft. Second best is usually an aircraft modified by the original manufacturer of the aircraft and third best is the after-market modification facilities. Some modification centre doors even have and continue to use the actual cut out piece of the fuselage itself as the new door, and do not use a jig or any additional structural support during the modification. Not only do these aircraft age, wear out and suffer the effects of time but so, as well, do the avionics and other components that make up a fully assembled, flyable aircraft. For many years replacements parts were produced for these older aircraft. But during the 1990s manufacturing switched to greater use of the more reliable computer chip. This change has meant older aircraft parts have often become hard to find, and many of those parts still in service have been repaired numerous times and are worn out. Increasingly being faced with tough competition It is now 25 years since the world‘s first frequent flyer program was launched. Today all most every airline, even a low cost carrier has a Frequent Flyer Program (FFP). The airline industry collectively earns $10 billion by selling AOMPS (Add On Mileage Points) and airline FFP memberships are growing at 13% per year, much faster than growth of airline industry. However, over the years, air travel in most parts of world has become a commodity, due to increased competition. FFPs have drifted away as main drivers for CRM strategy, their original purpose of ―promoting loyalty‖ to being‖ independent profit centres‖. Brand Positioning of the Airline with product and service differentiation Product differentiation and brand positioning of the airlines‘ premium classes,(F/J), have necessarily to be linked to airline‘ product vis-a-vis competition on each major route. The differentiation of products fulfils consumer promise nut needs to be at a competitive price. The value benefit of airline product has to be highlighted clearly by targeting promotional campaigns aimed at specific markets segments. Price versus product/service differentiation of the airline with its competitors is a crucial benchmark for building the brand equity of an airlines‘ loyalty program overtime. Transition from “frequent flyers” to frequent buyer”: In the dynamic market place of 21st century air travel, airline FFPs have tied up alliances with partners from credit cards companies, mortgage lenders, finance companies, fuel companies to corner grocery shops. Airline normally sells their miles for 1-2 cents per miles to such partners, as co-branding strategy. As a result, the majority of airline frequent fliers miles are now earned outside an airplane, by frequent buyers that frequent flyers. FFP Management from competitive scenario Ensure seats are protected in RBD for redemption Action on feedback from FFP members Keep track of FFP of other airlines Keep update on accrual/redemption ratios, etc. Keep update on blogs, websites like webflyer.com that give ratings for FFPs. Key success criteria From airline‟s point of view Integrate its FFP with alliance members and other airlines as well as, non-air partners‘ systems facilitating redemption and accrual across members Reduce liability of MPTs by expiring them, promoting the sale of expiring MPTs. Increase the frequency of and/or influence the customers‘ purchase Improve the service provided to members based on value Provide a mechanism to influence the behaviour and improve the profitability of the entire membership base. Direct marketing resources for optimal return on investment Enable FFP platform and processes to be performed at a competitive cost Create and enable partnership agreements, joint credit card promotions etc that earn additional revenue. Provide an additional promotional and payment channel to facilitate sale of in-flight goods. From customer‟s point of view Success in getting award travel Personalized service by airline in the following functions Accessing airlines‘ website Recognition by airline, e.g. a birthday gift like a bottle of wine on board aircraft, if travel date coincides with birthday Special assistance during irregular operations, delayed flights, etc. Web enabling key internal business processes Integration with alliance partner airlines‘ FFPs, giving wider options to customer Inadequate Cash Flow An airline‘s profits depend on its revenue and its costs. Revenue depends on what a carrier is able to charge for its flights and the number of passengers it carries. Costs depend on, among other factors, the price of fuel and the wages and salaries of employees. Number of passengers The good news is that, traffic (revenue passenger miles) in 2004 exceeded its previous peak in 2000. Negative traffic growth is a relatively rare occurrence in the airline industry—the last downturn is only the fifth occurrence of a negative year over year traffic growth since record keeping began in 1930. However, what is unprecedented about this drop in traffic is that it took four years for traffic to rebound. The recent downturn in traffic began in February 2001, one month before the recession that began in March 2001 (and ended in November 2001). The downturn was exacerbated by the aftermath of the September 11, 2001 terrorist attacks. Traffic growth has subsequently returned, but why? One reason is that GDP is growing. Since its trough in 2001:3, real GDP has been growing by more than 3 percent per year. Another reason is more travellers are feeling that flying is safe enough for them to travel by air. Still another important reason is that the airlines responded to the initial drop in traffic by reducing fares to induce people to fly. Fares Fares fell by 25 percent from 2000 to 2004 after adjusting for inflation. This substantial decline in fares has occurred only one other time in the United States, namely after capacity restrictions were eased following the end of World War II. Because of the dramatic decline in air fares, the rebound in traffic masks underlying changes in passengers‘ demand for air travel. Our ―back-of-the-envelope‖ calculations indicate that, under reasonable assumptions about the sensitivity of air travel to fare changes, in 2004 prevailing fares generated 17 percent less traffic than those fares would have generated in 2000 (with a plausible range between 6 and 25 percent). What has caused the change in passengers‘ underlying willingness to pay for air travel? Plausible reasons are that the airline ―product‖ has changed. Increased security leads to earlier arrival at airports and longer trip times; fuller planes—over 75 percent full on average, the highest since right after World War II—make travelling more unpleasant. And alternatives to air travel, teleconferencing and rail travel—at least in the Northeast Corridor— have become more attractive options. Consider as an illustration the effect on air travel of required earlier arrival at airports. If passengers must now arrive at their origin airport one-half hour earlier than previously, then, under plausible assumptions of relevant parameters, travel could decline 7 percent (a plausible range is 3 percent to 11 percent). In addition to these considerations, the travelling public, especially the (formerly) lucrative business travellers, are less willing to pay fares many times higher than their fellow leisure travellers. Labor Labor represents the biggest single category of airline costs, currently about 28%. ―Legacy‖ airlines, by definition, are those that existed during the period when airlines were regulated (through 1978). In that environment, there was so-called ―rent sharing,‖ as unionized workers sought, and received, a share of the ―rents‖ (profits) that the regulated firms earned. Low-cost carriers emerged with the advent of deregulation in 1978 and adopted a more entrepreneurial/cooperative style of labor relations that resulted in lower pay and/or higher worker productivity than legacy carriers were able to achieve with their work force. The expansion of low-cost carriers has put increasing pressure on legacy carriers to lower their labor and other costs. Since 2000 food and beverage costs per revenue passenger mile have fallen by 35 percent and travel agent commissions (per available seat mile) have fallen by 69 percent. But since labor is the largest category of airline costs, it too has been the target of cost cutting (and enhanced productivity) by legacy carriers, through negotiation as well as in bankruptcy, as they seek to reduce their costs to compete with low-cost carriers. Fuel In addition to unanticipated reductions in travel demand, the industry is vulnerable to unanticipated increases in costs. Jet fuel, a necessary input into the production of air transportation, accounts for between 10 and 30 percent of airlines‘ costs, and its price can fluctuate widely from year to year. Fuel price increases can be a significant drain on airline profits. Relative to the (nominal) price of jet fuel that prevailed in 2000—the last ―good‖ financial year for the airline industry (and one in which the price of fuel was relatively high by previous historical standards. What Can Be Done to Improve the Industry‟s Financial Performance? It may be surprising to some that the financial problem that the industry is currently encountering is broadly associated with the industry‘s long-term adjustment to airline deregulation. Airline deregulation was based on the correct belief that enhanced and unfettered market competition and enlightened public policy would benefit the travelling public. But it is now clear that the airline industry has needed and still needs time to adjust to its deregulatory freedoms by ridding itself of remaining cost inefficiencies, doing a better job of matching capacity with demand, and anticipating and responding to changes in traveller preferences. Both the market and enlightened public policy can enhance industry financial viability. But we believe that policymakers should rely on the market to do the bulk of the work. The fundamental problem is that there is excess high-cost capacity in the industry. Competition among air carriers will reduce such capacity and no doubt may lead at least one if not more carriers to contract, undergo liquidation, or be absorbed by another carrier. But successful carriers—that is, those that are cost efficient and responsive to passenger preferences—will be poised to pick up any slack. Indeed, travellers will gain if legacy carriers make the required changes to be effective competitors in the new environment or are replaced by lower cost carriers. Airline competition is working in the sense that those carriers that enhance traveller welfare are rewarded with higher profits. This is an important finding because it indicates that policymakers should not intervene in the competitive process. STRONG YIELD ENVIRONMENT NOW STABILIZING A substantial rise in yields has been the other element driving improved airline financial performance. As capacity lagged the rebound in traffic, supply-demand conditions tightened and yields improved as a result. This was most notable in US markets as the industry in this region made the most significant cuts in capacity. Now capacity is returning to markets and load factors have peaked. As a result yields appear to be levelling off. As traffic slows further through 2011, supply-demand conditions may ease further. Yields look reasonably well supported at current levels but further improvements look unlikely in 2011. Margins look set to be squeezed to some extent in 2011 by stable yields on the one side and rising fuel prices on the other side. We had previously expected oil prices to remain stable at US$79 a barrel. However, central bank liquidity and capital flows are threatening to generate asset and commodity price bubbles, helped by improved economic sentiment outside of Europe. We have revised up our forecast for oil prices to an average of US$84 a barrel in 2011. Higher oil prices, stable yields and weak traffic volumes originating from the developed economies cause some slippage in airline profits next year. Geographic differences will remain. Stronger growth in the emerging markets will support stronger performance from airlines based in those regions. European airlines will continue to be hampered by weak home markets. Inadequate Cash Flow We are upgrading our forecast for airline industry profits in response to a strong cyclical upswing in revenues and much better utilization of capacity by airlines. Our forecast for net post-tax profits in 2010 has been raised to US$15.1 billion, up from our previous forecast of US$8.9 billion. Better economic conditions, despite the European crisis, have supported stronger market growth and better aircraft utilization has driven a sharp upswing in profitability in all regions. Operating margins are now expected to exceed 5% this year, not as good as the late-1990s but better than the previous cycle peak in 2007. Airline profit cycles usually last 7-10 years, from peak to peak, implying that there are 4-5 more years to go before this cycle peaks. Nonetheless next year, 2011, may see smooth upward progression being interrupted as oil and jet fuel prices rise and some economies in Europe look set to be driven back into recession by debt crises. Emerging markets such as Asia-Pacific look set to continue to grow strongly but a weak Europe is expected to make the business environment for airlines more challenging than it was in 2010. With a stronger 2010 the starting point for industry profits is higher than we expected in our previous forecast. But we are still forecasting some slippage in net profits to US$9.1 billion in 2011. BUT AIRLINE RETURNS REMAIN INADEQUATE There has been a stronger-than-expected cyclical rebound in airline profits, but that rebound and the upgrades we are making to these forecasts need to be put into perspective. First, the US$6.2 billion upgrade to raise forecast net profits in 2010 to US$15.1 billion is just 1.1% of revenues. Because profits are so small, relatively minor improvements in revenues or costs can generate large changes in profits. Second, and more important, the cyclical rise in profits represents a rise to just over 4% in returns on invested capital. As the chart below shows this is still very inadequate. It shows that the industry can pay its bills, renew its fleet and service its debt. However, it still cannot offer any return to its owners and shareholders for the risk they undertake. Despite the cyclical rebound in profits, the structural challenges that keep profitability in the industry inadequate, remain. CASH FLOWS BACK TO PRE-CRISIS LEVEL BY Q3 During the first half of 2010 the recovery of operating cash flows had been concentrated in Asia-Pacific and the Americas, but by the third quarter a widespread cyclical recovery in cash flows was underway. Even the European airlines, hampered by weak home markets, saw their cash flows rise sharply in Q3 to just below the previous peak of 2007. A strong post-recession rebound in cargo and travel volumes had already driven the improvement in cash flows for Asia-Pacific airlines in late 2009/early 2010. Capacity cuts in late-2008 had more steadily improving performance for US airlines. The change that drove further improvement in Q3 and produced the European upswing was a sharp improvement in aircraft utilization. Airline operations are highly leveraged and improved asset utilization generates significant financial improvement. TRAVEL STILL STRONG BUT FREIGHT PAUSING Asia-Pacific airlines‘ cash flow performance has closely followed the fluctuations in air freight volumes, since this is such an important business segment in that region. After a very fast rebound through 2009 and into 2010 air freight peaked and has slipped back in recent months. The Q3 slippage in Asia-Pacific cash flow reflects this. The air freight cycle has been shaped by the business inventories – as firms sought to rapidly restock using air freight – but that cycle has now ended. This has caused the recent decline in air freight but continued economic expansion outside Europe is expected to generate a further leg to the air freight upswing, albeit at growth rates in single figures rather than the 20%+ growth of the inventory-cycle phase. During 2011 we expect Europe to generate the weakest flows of passenger traffic. Already governments have swung from providing a large fiscal stimulus, to turn economies around from recession to recovery, to implementing austerity budgets which will remove several percentage points of GDP from spending over the next few years. In addition the bank and sovereign debt crisis in Europe is forcing further measures that are expected to drive a number of European economies back into recession. On top of this challenging economic environment European governments are placing new or increased taxes on air travel. In the UK, Germany and Austria these amounts to additional travel costs representing 3-5% of ticket prices and so are likely to have a material adverse impact on travel demand. European airlines will be able to take advantage of stronger long-haul markets but even so, the weakness of home markets is expected to produce the weakest traffic growth in this region. The US economy is looking in better shape but debt is still a problem and below-trend growth is expected from this market. In non-Japan Asia, Latin America and other parts of the so-called developing world, economic growth is much stronger and expected to stay that way. Airline traffic growth is forecast to be much stronger outside Europe and North America as a result during 2011.
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