Is Airline Industry Risk Unmanageable?

By Michael Zea
Airlines in todays 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 sectors stock. Airline P/E ratios are generally half or a third of the market average, a fact often lamented by airline CEOs. Airlines that have shown consistent earnings have been rewarded with faster stock price growth. For example, Lufthansas earnings have been half as volatile

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as Air Canadas during the past 10 years, and its stock price has grown twice as fast. Air Canada now seems to be taking a page from Lufthansas strategic playbook by diversifying into airline-related services (e.g., setting up Aeroplan as an independent loyalty business). The primary risks facing the industry fall into four categorieshazard, strategic, financial, and operational (Exhibit 2). In general, airline risk management has been limited to hazard risk, such as the protection of physical assets, and significant attention of late has been given to safety and security issues. There has also been some experimentation with hedging financial risks, such as foreign currency exchange rates, interest rates, and fuel prices. Some of these approaches have been successful, but more aggressive techniques and a wider perspective would greatly increase the benefits.

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.g., strikes) Major IROPs

Hazard Risks

Terrorism/sabotage Weather

Operational Risks

One concept that can address this opportunity is Enterprise Risk Management, a process of systematically and comprehensively identifying all critical risks, quantifying their impacts, and developing and implementing integrated risk management solutions that align people, processes, and technology to maximize enterprise value. Some tenets of this approach include:
!

Not all risks are materialit depends on their potential impact on the value of the enterprise. Individual risks and their impacts should be evaluated on a portfolio basis to understand and appreciate correlations among risks. Risk management is an ongoing process, not a one-time event.

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Mercer recently analyzed aviation industry risks for the 10-year period from April 1991 to April 2001. This was a long enough period to capture the full range of the economic cycle, including the recession of the early 1990s, rather than focusing on the impact of one-time events such as September 11th. Overall, failure to manage the entire spectrum of risks resulted in the evaporation of $46 billion in shareholder value during this time period. Interestingly, hazard events, including safety, liability, and war, were the least likely to result in value loss. Strategic and financial risks were much more prevalent, accounting for nearly three-fourths of value loss events during the period (Exhibit 3).

Exhibit 3 Risk Events Precipitating Stock Drops, 1991-2001

10

6 Number of events 4 3 2 1 2 2 1 2 1 1 1 3 5 5

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.

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. A challenge from a new form of competition, shifts in customer preference, and industry consolidation are all strategic risks. Many of these challenges may be mitigated through traditional responses, such as creating a culture focused on the customer, developing a rigorous strategic planning process, 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. For example, Southwest has designed a business that attracts customers in good times and in bad because it is simple operationally and, therefore, cost effective. It is also not subject to the tremendous reliability

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problems that bedevil network airlines. Other Southwest business design choices further lower risk exposure. For example, use of secondary airports insulates Southwest from direct competitive pressure while improving turnaround speed. Low debt levels make the company less vulnerable to interest rate fluctuations. And profit sharing and a fun culture reduce the chance of labor difficulties. Southwests success is now being emulated in Europe, and threatening major network airlines on the Continent, as highlighted in a recent Mercer study (see the article Low-Cost Airlines Gaining Momentum in Europe in this issue). Financial risks involve the management of capital and cash, including exogenous factors that affect the variability and predictability of revenue and cash flow (e.g., general economic conditions or foreign exchange rates). Outside of hazard risks, techniques to mitigate financial risks are the most advanced, primarily because there is a large third-party market dedicated to the effort (banks, credit specialists, derivative markets, etc.). Financial solutions may include the design and placement of financial transactions, including, for example, structured finance, derivatives, insurance, contingent financing, and debt/equity offerings. There are other new approaches, as outlined in one of the examples below, which could push thinking even further in this area. Operational risks arise from the more tactical aspects of running the business day-to-day, such as crew scheduling, accounting and information systems, and e-commerce activities. Many airlines have processes in place to mitigate the most obvious operational risks (e.g., business interruption and IROPS), but fail to address more subtle risks. For example, little effort has been put into working with the government to shape industry regulation or solve capacity issues, yet airlines have spent tens of millions of dollars fighting inquiries and lawsuits, all the while incurring system delays. Operational risks can be mitigated through organizational solutions, for example, process redesign, organization structural changes, improved communication, contingency planning, performance measurement and reward systems, and capital allocation and pricing. Most managers would think of mitigating risks such as these as just part of doing their job. The challenge is great, however, and involves looking at risks holistically, as well as evaluating each potential response through the lens of impact on shareholder value. Then strategies can be defined to mitigate risk wherever it resides.

Case Examples Mitigating Strategic Risk

As mentioned earlier, Lufthansa has pursued a strategy of business design diversification to reduce the volatility of their earnings base originating from the passenger airline business. The program began in 1994 after three years of losses, with four companies being created: Lufthansa Technik, Lufthansa Cargo, Lufthansa Service, and Lufthansa Systems. Revenue growth has been highest in the service-related divisions, and passenger airline revenues now account for only 56 percent of the total, down from 70 percent in 1995. While Lufthansa is

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still reliant on the air transport sector, it is in a better position to reduce earnings volatility than its competitors, despite the fact that not all of the divisions have been successful. Swissair pursued a similar strategy but, unfortunately, also attempted to diversify geographically (within Europe) by investing in weak, second-tier airlines. Not surprisingly, the only value left in the company after the recent liquidity crisis was in the services businesses. Some airlines have contained strategic risk through aggressive cash management. Most airlines accelerate spending during periods of high growth to acquire new aircraft, upgrade products and services, and maintain labor peace. Airlines with the highest multiples, however, conserve cash during the boom times and invest in the trough. For example, during the Asian financial crisis, Singapore Airlines initiated hundreds of millions of dollars worth of upgrades to their onboard product, further entrenching their leadership position during the later economic upturn. Low-cost airline Ryanair recently placed an order for 100 Boeing 737s with 50 options, during a time when most airlines are deferring orders and mothballing aircraft. As a result, they were able to negotiate a low unit price, and are poised to further exploit the current weakness of Europes network airlines.

Mitigating Financial Risk

Hedging is a common way to manage the financial risk of input price changes, and no airline input is more volatile than fuel. Airline executives often comment that hedging is not a core competency, and that as long as competitors are not hedged, it will be a level playing field. Unfortunately, when fuel prices rise dramatically, airlines cannot pass all of the cost on to their customers. As shown in Exhibit 4, Mercer analyzed the effect of year 2000 hedging strategies among major airlines. While many airlines were able to maintain profits in the face of price increases, more aggressive strategies could have been used to further improve results. If such tools are not further leveraged, earnings will continue to be vulnerable, and shareholders will suffer value loss during volatile periods of supply.

Exhibit 4 Operating Income Effect of Fuel Hedging

2.5
Operating profit before fuel effects Operating profit increase due to fuel hedging Loss in operating profit due to fuel price increase

2.0

1.5

2000 EBIT per ASM 1.0 () 0.5

-0.5

Southwest

Singapore Airlines Delta

AMR

Northwest Qantas

UAL

Air Canada British Airways US Airways

TWA

Lufthansa

Cathay Pacific

Continental

Source: Mercer analysis.

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An example of a new technique for financial risk management involves guarantees for credit card transactions. This product, developed by MMC Enterprise Risk, allows an airline to access otherwise unavailable cash (e.g., credit card escrow funds). Normally, the bank processing a weakened airlines credit card transactions will put all of the funds into an escrow account, to be released as customers use their tickets. This protects the bank against refund requirements should the airline cease operations. In the new arrangement, shown in Exhibit 5, a guarantor insures the refunds to the bank, which then releases the cash in the escrow account. 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. Insurance capacity can typically provide a flexible risk mitigation avenue, without exposing the insurer to undue risk of losses. This arrangement offers the airline access to additional funds at a lower than average cost of borrowing, at a time when traditional funding lines are strained due to the industrys weakened financial state.

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, from the escrow account, 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. Ten could have been mitigated through traditional means such as insurance or financial derivatives. Fourteen events could have been mitigated by more consistent and in-depth customer analysis, combined with scenario planning and game theory exercises. Finally, eight events could have been mitigated through improved merger integration planning and improved execution. In summary, given the many new tools available, it is time for airlines to move to the next level of sophistication in Enterprise Risk Management. The impact of one-time value-destroying events and related earnings volatility would be reduced, and shareholder value dramatically improved. As James Lam, former Chief Risk Officer of Fidelity Investments and GE has said, leaders recognize that over the long-term, the only alternative to risk management is crisis management. Phil Bolt, a Managing Director at Marsh Ltd.s London office specializing in risk services for airlines, also contributed to this article.

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