Recently Embraer announced a set of Economic Metrics based on the concept of return on investment capital that illustrates how “right sizing” aircraft in the 70-110 seat segment can make sense for airlines.   In the paragraphs that follow, we will review their analytics and relate it to the health of the industry and competitive behaviors that currently exist in the industry to test how this theory meets reality.

Recently, we’ve seen a tremendous upsurge in orders for larger models of the Airbus A320 family and Boeing 737 family, particularly when compared to past deliveries. The following chart shows historic deliveries of those aircraft families by size through 31 March 2015.

e1But when we look at orders for the next generation of narrow-bodies from Airbus and Boeing, the neo and MAX, the order distribution has changed dramatically, as shown below.

e2While historically nearly 25% of the market, the A319neo and 737 MAX7 have generated less than 2% of new orders, a sizable shift. Does this mean that airlines are abandoning the 120-130 seat aircraft for the foreseeable future in an effort to gain better seat-mile economics, or is there an opportunity in “right sizing” aircraft to meet the needs of smaller markets? Let’s explore the theory and its dynamics.

The theory behind right sizing is that continual up-sizing of aircraft is a somewhat futile effort. In the diagram below, Embraer illustrates their concept of the Vicious Cycle of capacity growth and yields. It all comes down to the market share battle, which drives lower costs with larger aircraft, but increases capacity, which then results in lowers yields – resulting in a downward spiral of profitability. The question is when, and how, to stop the spiral.

e3We have seen this occur on several occasions in the past — in the United States post deregulation, resulting in the failure of many carriers, and today with low cost carrier and ultra low cost carrier competition in Europe and Asia eroding the profitability of the industry by lowering yields.

Perhaps the best illustration of defending every inch of market share occurred in the 1980s in the United States. Arrow Air, a charter airline with limited scheduled service, needed to reposition a flight from Miami to New York on a Sunday evening, and rather than fly it empty, offered a one flight per week scheduled service at $99 each way. Eastern Airlines soon matched the fare on their non-stops, which Delta then matched on their connections through Atlanta. Within a week, this escalated to a fare war that resulted in $99 one way fares throughout the country, and all airlines began to bleed financially as a result of diminished yields – caused by one repositioning flight.

While we have not seen such radical swings in quite some time, there are several economic drivers that are influencing the market, not the least of which is the expansion of low fare carriers. A decade ago, in 2004, LCCs were mature in the United States, with 35% of the market, but just emerging in Europe and Asia, with 18% and 6% respectively. By 2014, the US share had moved to 45%, while Europe more than doubled to 42% and Asia quintupled to 34%. The massive growth of LCCs in Europe and Asia has fueled the demand for larger narrow-bodies with lower seat-mile costs.  Yields have fallen.

If we examine the world markets, and examine competitive behavior, the fight for market share is active in most regions. The US market, which has consolidated and maintained capacity discipline, appears to be the one bright spot in the world with respect to return on invested capital. In other segments, destructive competition still rules the day, with carriers like Ryanair, LionAir, and the Indian LCCs reducing fares below generally profitable levels. The following chart illustrates several key characteristics of the industry geographically, with green indicating achievement of that characteristic, yellow being partially there, and red indicating that the industry hasn’t arrived yet.

2015-06-03_8-01-55Cost harmonization has occurred within the United States, as post-bankruptcy, legacy carriers were able to reduce wages and benefits and match low-fare carriers in their cost structures. This is yet to happen in Europe, Asia, or Latin America, where significant cost disparities between legacy, LCC, and ULCC carriers remain. Consolidation has occurred to nearly a full extent in the US, with six major legacy carriers merging into three. This oligopoly, along with Southwest, has basically maintained capacity discipline, and squashed attempts of new entrants into the market through aggressive price competition, and has developed a robust revenue model that includes ancillary revenues.

That model has not yet spread to the rest of the world, however. While there has been some consolidation in Europe and a hint of capacity discipline, costs for legacy carriers remain much higher than LCCs and especially ULCCs, which continue to enter the market. As a result, the revenue model in Europe is not robust.   Asia has experienced explosive growth in LCCs, which are changing the market dramatically for legacy carriers, and resulting in unprofitable yields in many markets. Carriers in India routinely price below cost, which is unsustainable. Latin America, while consolidating with LAN-TAM and TACA-Avianca groups, has also not yet reached the point of capacity discipline.

How far can the vicious cycle continue before it reaches it economic limits and forces airlines to fail? We’ve seen examples of this in Europe, with WizzAir forcing Malev out of business in Hungary, and Aegean forcing Olympic out of business in Greece — all this several years after Swissair and Sabena failed in their respective countries, only to be resurrected with new names and ownership. In India, Kingfisher could not gain traction, and several of the low cost carriers are teetering on the brink. In Southeast Asia, Malaysian is restructuring after two unfortunate accidents, and low fare competition has eroded the profitability of the traditionally profitable legacy carriers.

Revenues for LCCs and especially ULCCs rely on ancillary revenues from everything from baggage fees to selling food on board the aircraft. While these have been beneficial to the bottom line, growth in ancillary revenues is unsustainable, unless fees for using the restroom come into play. Fundamentally, the commodity nature of the airline market means that the lowest cost producer will lower fares until the higher priced producers can no longer compete. This commodity view of the world tends to drive that vicious cycle.

Is capacity discipline a necessary condition for “right-sizing” aircraft, or can smaller aircraft be effectively introduced into the rest of the world as well as in the US market?

The answer is perhaps – if an airline changes its measurement metric to Return on Invested Capital and away from market share and revenue growth. Shareholders are increasingly demanding a return on their investment, something for which airlines have a poor track record. Breaking the cycle requires a change in mindset, and examining the true nature of demand curves, fares, and profitability.

Embraer believes that if one utilizes ROIC rather than market share or revenue growth as an economic target, behaviors will change. Those behaviors center about the demand elasticity for seats on an airline flight, as shown in the chart below. The number of passengers who are willing to pay a high price (last minute business travelers who have no choice) versus the number of passengers willing to pay a little for vacation travel has a rapidly diminishing slope.

e4That leads directly to the selection of the “right sized” aircraft for each market. A larger aircraft will bring more overall revenues, but at a lower level of revenue per seat, as the additional seats need to be filled with low fare customers. A right-sized aircraft might result in up to 30% higher revenue per seat, but with fewer seats, bring less overall revenue.

Citing a hometown example, Embraer compared Azul with a 110 seat aircraft with GOL, which uses a 170 seat aircraft. Their data indicate that Azul is earning about 50% more profit per seat than GOL through the use of smaller aircraft. Embraer presented one representative example, with four different fare buckets, that indicates a revenue of $119 per seat as shown in the figure.

e5The comparable figure for the larger aircraft shows an average revenue per seat of $91 given a similar mix of traffic by class.

e6The new math can make sense, particularly if the market is saturated. But in the analysis above, the market accommodates 24 more passengers for the larger aircraft at the lower price points. The key to this analysis is the market elasticity, which differs for each city pair, and even by day of the week, and time of day.

Airbus and Boeing, by contrast, talk about additional profit potential, and not leaving any potential passengers behind by using larger aircraft than the market needs, accommodating peak days without problems. But every week does has a Tuesday, with slower traffic, and a busy Friday when everyone wants to get home.

The dilemma faced by an airline is whether it wants potential spillage and higher yields — turning away potential customers during peak days and right-sizing an aircraft to the market — or offering a larger aircraft and accommodating everyone, but suffering lower yields.

Revenue per seat is one side of the equation, as cost per seat is another element. While revenue per seat is typically higher for a smaller aircraft, costs per seat are typically higher. Overall, however, the differential in revenue tends to be higher than the difference in cost, resulting in higher profitability for the smaller aircraft on a per seat basis.

Return on Aircraft Assets (ROaA)

Embraer has developed a Return on Aircraft Assets metric that is interesting. They calculate this metric by taking profit per seat, dividing it by asset value per seat, providing a profit to asset value relationship. The key to this analysis is that the profit per seat is not simply a straight RASM-CASM calculation, but recognizes the differential yield curve with traffic levels to more accurately estimate revenue potential.

And with that added profitability, Embraer believes that the vicious cycle can be turned into a virtuous circle – and upward rather than downward cycle.

e7

The Bottom Line:

The tradeoff for an airline in right-sizing aircraft to specific routes entails a number of factors, including traffic and yield elasticity, as well as frequency of service. In an ideal world, where carriers aren’t focused on market share, right sized aircraft provide the ideal solution. But for LCCs trying to win in commodity markets through lower fares, seat-mile costs remain the driver.

Over the last few years, there has been substantial growth in LCCs and ULCCs, but that rate of growth appears to be slowing. With slowing growth of ULCCs, and fewer markets for new entrants, the opportunity for smaller “right-sized” aircraft will likely soon be at hand. This bodes well for Embraer’s E2-Jets, Bombardier’s CSeries, Mitsubishi’s MRJ and Sukhoi’s Superjet.

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