Airline Industry Analysis
The past decade has been a challenging one for the global airline industry. The terrorist attacks of September 11, 2001 sent the industry into a downturn in the first half of the decade, while the second half of the decade saw skyrocketing jet fuel costs and economic downturn send passenger numbers down and costs upward. In addition, the nature of competition within the industry has seen tremendous change. Discount carriers like Ryanair and Air Asia have reshaped the low end of the market while at the upper end several Gulf-based carriers have established themselves as global players at the expense of Europe and Asia’s legacy carriers. As a result of these changes to the competitive and macroenvironments, the airline industry is in a state of creative destruction today, making it one of the most challenging industries in which to operate, yet also an industry in which there is tremendous potential for growth for companies with a good business model.
This paper will analyze the global airline industry in the context of its macroenvironment, including both a Five Forces and a PESTLE analysis. The life cycle of the industry will be analyzed, and the additional topic of security will be discussed, as this subject has also had a high impact on the direction of the industry in recent years. After this analysis has been conducted, an analysis of the industry using a resource-based perspective will be conducted. Air travel is a confluence of a number of critical resources, each of which can yield significant competitive advantage to a firm.
Five Forces Analysis
Michael Porter’s Five Forces are supplier power, buyer power, threat of substitutes, threat of new entrants and intensity of rivalry. When put together, these forces can help understand the degree of attractiveness for the industry. For firms within the industry, their position within these forces may also dictate the industry’s attractiveness (for example a firm with high power over suppliers in an industry with generally low power over suppliers). The five forces are graded on a low-medium-high scale, and the attractiveness will be determined by putting these five scores together (QuickMBA/Porter, 2007). The airline industry is generally unattractive at present, although for some firms the condition of the industry has resulted in significant opportunity to steal market share from weakened legacy carriers.
There are several suppliers to the airline industry — key cost inputs include labor, airplanes and jet fuel. Supplier power is generally high. Labor suppliers are an exception as they have relatively low power over airlines. The airlines offer thousands or tens of thousands of jobs each. Much of the labor is not specialized, reducing its power. Even that labor which is unionized can be circumvented by the airlines if necessary — ground crews have limited bargaining power when airlines can simply fly their planes to another country to have them serviced. Airplane manufacturers have only moderate power over airlines. The suppliers are more concentrated, which should give them buyer power but the intensity of rivalry between the two major players (Boeing and Airbus) is very high. In addition, the airplane manufacturers have high fixed costs, which means they must sell a sufficient number of aircraft to cover those costs. They need the airlines as much as the airlines need them. The result of this symbiotic relationship is that aircraft suppliers have moderate power. Jet fuel suppliers have high bargaining power over airlines. The price of jet fuel is determined by global commodities markets, which gives airlines almost no pricing control. As a result, airlines are compelled to use sophisticated hedging strategies in order to manage their fuel costs. Even with these strategies, fuel costs can be virtually the sole determinant of airline profitability, as was the case during the fuel cost run-up from 2004-2008 (ATA, 2006).
Power of buyers is moderate in the airline industry. Buyer volume is low, but other factors drive buyer power such as information, price sensitivity, substitutes and competition. Buyers have a high degree of information available to them, in particular online, that allows them to compare prices, routes and flight times of a wide range of carriers. For most major journeys, there are myriad options available, and since buyers can easily compare these options, it gives them some bargaining power — not as much for negotiation but certainly for choosing one carrier’s offer over another’s.
Most airline buyers are price sensitive, not only in choosing between airlines but also in choosing between airlines and substitutes. There is evidence that price sensitivity of airline passengers, including business passengers, has increased significantly in recent years (Shane, 2004). That said, airlines set the prices. Most airlines use sophisticated algorithms to set their prices according to demand conditions, timing and a wide range of other factors. This allows airlines to maximize revenue for each flight — a combination of load factor and price per passenger. The bargaining power of buyers is also dependent on substitutions. For trans-continental flights, airlines have significantly more bargaining power in the absence of land-based options such as railways and roadways. On routes within continents, airlines have reduced bargaining power, exceptions given to long-distance flights.
The threat of substitutes is moderate to low. This is dependent on the particular route — intercontinental routes and long-distance routes within the same continent have a low threat of substitutes as alternate transportation modes are lengthy, time-consuming or downright impossible. On short and medium routes that do not cross large bodies of water, there is a moderate threat of substitution. Air travel is much faster than any other mode, giving it a distinct competitive advantage over other types. However, on these routes, price sensitive consumers may choose land-based modes of transportation. Air travel would then typically appeal more to time-sensitive consumers. An additional threat of substitution comes from forms of communication, in particular from business customers. It has been noted that during difficult economic times, companies will sometimes reduce their business travel expenses and utilize email, telephone, videoconferencing and other modes of communication in place of personal meetings. While evidence shows that videoconferencing is, of itself, a relatively low threat with substitution rates between 2.5-3.5% (Denstadtli, 2004), airlines often run flights where the profitability margin is only a few passengers, so at uptick in any substitution form could compromise profitability in the industry.
The threat of new entrants is relatively high. Despite would appears to be high fixed costs, economies of scale, a steep proprietary learning curve and high capital requirements, there appears to be no shortage of companies able to start airlines. Most of the industry’s strongest competitors today have emerged in the past twenty years, including the majority of discount airlines and the Gulf airlines. The ready availability of surplus airplanes, access to secondary airports and the demand among consumers for improved airline service all contribute to the high treat of new entrants.
The intensity of rivalry is moderate. There is low concentration in the global industry and air travel capacity appears to be sufficient to allow for new entrants. Corporate stakes are relatively low, as is the diversity of rivals and product differences. Despite these factors, the number of competitors and geographic specialization of national-based airlines has allowed for the industry to develop without strong rivalry.
Overall, the airline industry is generally unattractive. It probably should not be, given the forces acting upon the industry, but the airline business is anomalous in many respects. The pricing power of suppliers is generally high, and the pricing power of buyers is moderate, meaning that airlines are limited in the degree to which they are able to pass price increases along to their customers, most notably on intercontinental flights were substitutes are almost non-existent. The high threat posed by new entrants is another factor that makes the industry unattractive.
The political environment has a strong influence on the airline industry. Airlines are heavily regulated, both for safety reasons and for strategic reasons. Many national carriers are subsidized or owned by governments and this assistance at times has a direct impact on industry competition, such has been suggested of the Gulf-based carriers such as Emirates, which was financed by Dubai’s royal family (Pae, 2008). The political environment has also in recent years impacted the industry on the basis of its security procedures. Not only have airports been compelled to implement more sophisticated security measures, reducing passenger counts, but airlines have been forced to invest more in security themselves. In the U.S., increases in security costs since 2001 have run at an estimated $5.6 billion annually (Grossman, 2007). Due to the fact that airlines only have moderate pricing power over the customers, the industry has had to absorb part of these costs.
The economic environment has a strong influence on the airline industry. Air travel is strongly correlated to the global economy. As a consequence, the industry has faced a significant decline in demand since the outset of the economic downturn (Freeman, 2009). There are signs, however, that the economy is improving. Western economies with stable banking systems, such as Canada, are already raising interest rates and even in nations with weak banking systems such as the U.S. are seeing modest improvements in economic indicators.
The social environment is favorable for air travel. The mode still holds tremendous cachet with consumers and is favored when consumers can afford it. There is some consideration that the airline business is a major contributor to greenhouse gases and therefore global warming, but as of yet the industry has not come under serious public pressure as it is generally viewed by the public as a necessity rather than a luxury in this regard.
The technological environment is favorable, and the airline industry has typically responded well to technological change. While some developments are in the form of new airplane technology, for airlines the more important developments are those that reduce back-end costs. For example, the use of online reservation and check-in has been a core strategy for discount airlines to reduce costs (Starmer-Smith & Alleyne, 2009). Information technology has also facilitated other developments such as large airline code-sharing groups.
The legal environment concerning airlines is complex. The industry is highly regulated and in some cases — such as security – that regulation is shifting. Because airlines often fly between different countries, they are subject to the laws governing multiple nations. Airlines in general have little difficulty navigating their legal environments but the complexity of these environments can occasionally be a threat to a route or its profitability.
The airline industry has a heavy impact on the environment. This places it at risk with regards to sanction or legal action in future. However, the industry’s environmental impacts have yet to come under significant scrutiny and no talk of economic sanction has resulted from the environmental impacts of the airline business. As a result, this environment does not yet have a strong impact on the airline industry, even if it has the potential to do so.
The different environments paint a picture of an industry that is generally favorable. The economic environment presents the most significant challenge to the airline industry, with the political environment also having a strong impact. The other environments are generally favorable, at least for the time being. The airline industry has been able to dodge the major threats in most of its environments, with the notable exception of the economy, to which the fate of the industry is inextricably tied.
The resource-based view is a means of analyzing a firm in the context of the resources or tools it has at its disposal (Wernerfelt, 1984). The resources must be either valuable, rare, inimitable or non-substitutable in order for the firm to be able to use it to gain competitive advantage or preferably sustainable competitive advantage. Resources can be any of assets, capabilities, processes, firm attributes, knowledge that the firm controls.
The best way to analyze the airline industry from a resource-based perspective is to analyze the most successful companies in the industry to understand from where they draw their sources of competitive advantage. Critical resources that have been identified are systems, routes, corporate culture and strategic alliances.
Airlines can succeed by developing systems that have a lower cost structure than similar systems at competing airlines. For example, many discounters operate with a system that emphasizes online booking, and Ryanair has extended this to include online check-in (Starmer-Smith & Alleyne, 2009). This has allowed the company to have a lower cost structure than many of its competitors, who cannot do away with manual check-in gates.
Pricing systems can also allow an airline to gain competitive advantage. Unlike some other operating systems, pricing systems have more potential to be proprietary and therefore be considered “rare.” Airline pricing strategy is based on complex algorithms. These algorithms both help the airline forecast demand and set prices. The result is that they should deliver to the airline the optimal combination of ticket sales and ticket prices to maximize revenue (Knapp, 2003). The airline with the best algorithm should in theory have the best revenue optimization.
Airlines also derive competitive advantage from the route they hold. The routes can range from valuable to non-substitutable depending on the route’s distance and exclusivity. This resource arises from the limited capacity of airports and the fact that some major markets consistently bump up against this capacity. For many airlines, access to key airports is a critical success factor. In many cases, an airline can have a dominate position at a given airport, arising from either competitive strength or from government decree. Such access allows the airline to extract higher rents for flights to and from that airport. Access to transcontinental routes is also considered valuable, since those routes are not readily substitutable. Airlines with exclusive access to those routes can charge higher rents, effectively subsidizing operations on more competitive routes. Qantas, for example, used the Sydney-London and Sydney-Los Angeles routes to help it compete domestically against carriers unable to service those highly profitable routes.
In addition, certain geographies can be used to competitive advantage. In the United States, many airlines tend to fly a hub-and-spoke system. This means that for most airlines, finding a supportive and low-cost hub or handful of hubs, each with strong geographic location, is crucial to the development of the business. Central hubs such as Dallas-Fort Worth or O’Hare are particularly strong bases of operations from which to build networks that span the entire country. Similarly, international airlines use this model to gain competitive advantage. Taiwanese airlines such as EVA and Air China use this model to drive trans-Pacific business from a range of Asian cities and the Pacific coast of the Americas, often in conjunction with code-sharing agreements. The Gulf-based carriers have used their geographic location to develop route networks that match up cities in Europe with cities in Asia, including small and mid-sized airports. As an example, a consumer flying between two major cities such as Istanbul and Kuala Lumpur might have been required in the past to make multiple plane changes; today, one change in the Gulf can make such a route happen. This has been a tremendous source of competitive advantage for the Gulf-based airlines as there are no geographic competitors between Europe and Asia due to the large number of unstable countries in that corridor.
Corporate culture can also be a source of competitive advantage. This firm specific attribute can be duplicated by other airlines, but not easily. Perhaps the best example of building corporate culture to a source of competitive advantage in the airline industry is Southwest Airlines. This company’s culture was forged in part by the vision of early leadership and the need to acquire strong employee buy-in for the firm’s strategies, and partly as a response to the genuine threats the firm faced from larger competitors. The Southwest corporate culture delivers consistently higher levels of customer service and high commitment to cost reduction, each of which supports the company’s two main strategies. As a result, Southwest has been the most consistently profitable airline in North America. In the Gulf, the culture of excellence has been cultivated at Etihad, to drive the high levels of service that differentiate that airline. These examples show how culture has been used to foster both a low-cost strategy and a differentiated strategy.
Strategic alliances also form a source of competitive advantage in the airline industry. For many airlines, a means to increase capacity is code-sharing, often in large industry blocs. These blocs can help airlines to increase their capacity, by sending customers of other airlines to their airlines. The Star Alliance is one such bloc, comprised of airlines around the world. These alliances also allow for improved marketing synergies between the members of the group.
Because the resource-based view is internally-focused, it allows for insights that the design school models leave out. The airline industry is complex, so there are a number of different factors from which success can be generated. The design school models, such as the PESTLE and Five Forces, are useful in describing the external environment in which the airlines operate. For a specific airline, the SWOT analysis can provide some insight into the potential strategic directions going forward. These tools are useful in that they compel the manager to consider a broad range of variables that can impact on the business.
Compared with the design-school models, the resource-based view allows the manager to understand which of the company’s assets and systems can be used in order to gain competitive advantage, and to what degree that competitive advantage exists. Managers can easily analyze the success factors for competing airlines and weigh these against their own strategy. The resource-based view is perhaps most analogous to the “strengths” component of a SWOT analysis, but is more in-depth because it focuses the manager on a wider range of variables. When undertaken on an industry-wide basis, the resource-based view can shed light on resources utilized by all competitors, not just the one firm.
The resource-based view of strategy can be an especially powerful tool when matched against some of the design school models; the two approaches are complementary rather than mutually exclusive. In particular, the design school’s analytical tools provide the backdrop of knowledge against which it is easier to understand how the different resources can lend an airline competitive advantage. Once the industry conditions are understood, it is easier to understand how some firms are able to thrive in the same circumstances in which other firms struggle.
One area where the resource-based view appears to have considerable advantage over the design school models is that it is more focused on building sustainable competitive advantage. A SWOT analysis, for example, can reveal opportunities that an organization can exploit, but these opportunities may be short-lived, easily duplicated by competitors or otherwise limited in their value. It is not that such opportunities should be passed over, but they are inherently ephemeral in nature if they do not result in the firm creating sustainable competitive advantage.
The resource-based view focuses management away from chasing such short-term opportunities and towards activities where the organization can generate sustainable competitive advantage. To illustrate this, consider the example of Ryanair. That airline was launched to exploit an opportunity in the marketplace for a low-cost provider of airline services. Naturally, as Ryanair became successful, a wide range of competitors entered the marketplace with the same strategy, something that could have been predicted by the relatively low barriers to entry in the industry. The success of Ryanair initially was attributable to the company identifying and exploiting an opportunity — all of which could have been done utilizing design school models. That Ryanair has continued to be the industry leader in terms of pricing and market share despite a host of competitors entering the market can only be explained by taking a resource-based view. The company was able to build a corporate culture that facilitated constant cost-cutting initiatives. It was able to build a strong brand, and was able to forge strong relationships with key airports that gave it a first mover advantage over new entrants. Some of these competencies are imitable, but not perfectly so. In essence, other companies can come close to Ryanair in some respects, but cannot beat Ryanair in all respects. As a result, Ryanair remains the industry leader in the European discount airline business. It is only through the resource-based view that we are able to understand precisely how Ryanair has been able to sustain its success over the long-term.
The airline industry is a difficult one in which to operate and is moderately unattractive, but over the course of the past decade a number of firms have demonstrated two key things about the business. The first is that there are opportunities that can be exploited. With most legacy carriers operating more or less the same business model, firms with more creative models have been able to differentiate themselves and win market share. The second thing is that some of these advantages are sustainable. The legacy carriers have suffered in the past decade in part because they had so few sources of sustainable competitive advantage. The new carriers that have emerged and taken large amounts of market share have been much more competitive. Their strategies have been more comprehensive, and stem largely from a resource-based view used in conjunction with traditional design school analysis, whereas the legacy carriers have not demonstrated this degree of strategic competency. The result is that not only are the new carriers, both discounters and luxury airlines, winning market share and growing rapidly, but they are doing so in a manner that is sustainable over the long run.
Adapted from Porter, M. (2007). Porter’s Five Forces. QuickMBA. Retrieved March 30, 2010 from http://www.quickmba.com/strategy/porter.shtml
No author. (2006). Rising jet fuel prices hamper airline industry’s extraordinary cost-cutting efforts. Air Transport Association (ATA). Retrieved March 30, 2010 from http://www.airlines.org/news/releases/2006/news_4-11-06.htm
Shane, J. (2004). American Bar Association 2004 annual meeting aircraft financing subcommittee. U.S. Department of Transportation. Retrieved March 30, 2010 from http://ostpxweb.dot.gov/s-3/data/aba%20finance%20subcomte%20speech%20%20%288-6-04%29.pdf
Cote, J-P., Marcotte, P., Savard, G. (n.d.) A bilevel modeling approach to pricing and fare optimization in the airline industry. Universite de Montreal. Retrieved March 30, 2010 from http://www.iro.umontreal.ca/~marcotte/ARTIPS/RevMan2.pdf
Denstadtli, J. (2004). Impacts of videoconferencing on business travel: The Norwegian experience. Journal of Air Transportation Management. Vol. 10 (6) 371-376.
Pae, P. (2008). Dubai’s Emirates Airline eyes U.S. To reach lofty goal. Los Angeles Times. Retrieved March 31, 2010 from http://travel.latimes.com/articles/la-trw-emirates7jan07?page=1
Freeman, S. (2009). As air travel stalls over economy, airlines deals take off. Washington Post. Retrieved March 31, 2010 from http://www.eturbonews.com/8277/air-travel-stalls-over-economy-airline-deals-take
Starmer-Smith, C. & Alleyne, R. (2009). Ryanair to remove airport check-in desks. The Telegraph. Retrieved March 31, 2010 from http://www.telegraph.co.uk/travel/travelnews/4736024/Ryanair-to-remove-airport-check-in-desks.html
Grossman, D. (2007). An airline industry wish list. USA Today. Retrieved March 31, 2010 from http://www.usatoday.com/travel/columnist/grossman/2007-06-11-airline-challenges_N.htm
Wernerfelt, B. (1984). A resource-based view of the firm. Strategic Management Journal. Vol. 5 (2) 171-180.
Knapp, L. (2003). Algorithms key to cheap air fare. Wired. Retrieved March 31, 2010 from http://www.wired.com/science/discoveries/news/2003/04/58353
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