North America Rethinks
At a Glance
- North American airlines continue to be profitable, though this past performance is not guaranteed in the future with a combination of factors looking to end a five-year run of improving earnings.
- There is a need to align capacity planning with GDP estimates, in order to maintain stable profit margins.
- Airlines continue to use larger hubs for long-haul flights, with a need to right-size aircraft in their hub-and-spoke networks.
- Business travelers continue to value frequency, demonstrating an opportunity to run smaller capacity aircraft more often in flight schedules.
The North American airline industry continues on a profitable path. The region has been consistently delivering the strongest financial performance, with the highest profit margins in the current up cycle. According to IATA, North American carriers averaged more than 14% EBIT margins over the last two years.
Structural changes – notably airline consolidation and capacity discipline – have had a widespread implication for the region. There is no doubt they have been the key factors in the airline industry’s transformation into a more profitable, investment grade business.
By restricting the amount of available capacity, airlines were able to carry a greater percentage of higher-fare passengers, increasing both unit revenue and load factor simultaneously.
An End to the Boom?
A soft landing is expected as we move into 2017. Higher input costs, fuel and labor mainly, combined with softening passenger revenue per available-seat mile (PRASM), a proxy for pricing power, are set to spell an end to a five-year run of improving earnings.
While a focus on short-term thinking is comprehensible, a long-term approach is critical. The airline industry is notoriously known for its boom and bust cycles and the cyclical behavior is mostly internally generated. Better seat inventory control allows a continuous search for higher profits and efficiency. It is important that carriers do not lose sight of the discipline. The ability to shift back towards revenue unit growth, instead of aggressive capacity expansion, is crucial. The recent decline in unit revenue coincides with a slight relaxation of capacity restraint in the industry.
While load factor is the most commonly used measure to indicate better utilization of aircraft capacity, PRASM validates an airline’s ability to generate higher revenue per seat. This is essential to increase margins. Right-sized aircraft are the best tool to combine growth and higher returns.
North American airlines must plan future capacity addition largely in line with GDP estimates and assure the increases remain in line with the philosophy of rational growth. Thankfully, low jet fuel prices provide a buffer against the softness in pricing power, which should still result in robust profits. However, the loss of pricing tractions is not viable over the long run. Airline executives must focus on rewarding investors and profit maximization, rather than winning market share.
* Correlation (R2 = 0.73) (see graph to the right)
Capacity Expansion and Pricing Power – North American Airlines (2016 x 2015)*Source: Airlines, Embraer
Time to Right-size
The ongoing need for operational efficiency demands an increasingly central role of right-sized aircraft in the US domestic environment to sustain and improve the financial health achieved so far. As a result of the recent evolution of scope clause and airline consolidations, major carriers have grounded hundreds of 50-seat regional jets in an effort to rationalize the network. Jets in the 70 to 90-seat category have been the cornerstones of the hub-and-spoke system. The latest round of scope clause negotiation allowed U.S. major and regional carriers to order 400 76-seat jets with high-value premium seating, mostly to serve markets traditionally flown by 50-seat jets.
Interconnectivity in the Region
The routing strategy implemented in the major hubs with regional jets allowed airlines to serve more markets with its existing resources and tighten connections to transfer passengers from all spoke locations into one major hub.
The Chicago-Frankfurt market is an example of the importance of regional jets to keep inter-connectivity in the hub and spoke system. More than 40% of all passengers flying to Frankfurt connected in O’Hare in a regional jet before heading to Germany. Regional jet passengers account for 35% of Trans-Pacific flow traffic via Detroit to Tokyo Narita and 30% of the Latin flow traffic via Los Angeles to São Paulo.
Focus on Frequency
Regional jets are not only important for hub feeding. According to a survey conducted by Ipsos on behalf of Airlines for America (A4A), frequency is extremely important to strengthen airlines’ presence in high-yield business markets. When choosing an airline, business travelers value schedule above all else, a convenience that cannot be provided exclusively by large-capacity narrow-body aircraft.
Stability in Uncertainty
The latest round of scope negotiation introduced the concept of the small-narrow-body, a 100/120-seat jet operated by the mainline with a different pay scale – typically in the range of 20% to 30% lower than current and future narrow bodies pilots pay – which will be key for airlines to expand with incremental capacity and lower risk. It is a compelling economic alternative to the current domestic environment in North America.
In this context, small narrow-bodies will play an increasingly important role through the ups and downs of business cycles in the US domestic environment, helping to sustain and improve the country’s financial health. The category will become crucial to this new age of stability and healthier financial results, through the fluctuations of North America’s business cycles, while combining growth and higher returns with the opportunity to increase unit revenue with a right-sized aircraft.