airlineinvestor wrote:
Unjustly imprisoned, a tinsmith was allowed to receive a rug woven by his wife. He prostrated himself upon the rug day after day to say his prayers, and after some time he said to his jailers:
“I am poor and without hope, and you are wretchedly paid. But I am a tinsmith. Bring my tin and my tools, and I shall make small artifacts which you can sell in the market, and we will both benefit.”
The guards agreed to this, and presently the tinsmith and they were both making a profit, from which they bought food and comfort for themselves.
Then, one day, when the guards went to the cell, the door was open, and the tinsmith was gone.
Many years later, when the tinsmith’s innocence had been established, the man who had imprisoned him asked him how he escaped, what magic he had used?
The tinsmith said: “It’s a matter of design, and design within a design. My wife is a weaver. She found the man who had made the locks of the cell door, and got the design from him. This she wove into the carpet, at the spot where my head touched in prayer five times a day. I am a metal-worker, and this design looked to me like the inside of a lock. I designed the plan of the artefacts to obtain materials to make the key – and I escaped.”
The importance of the
design and what we
attend to are major themes in this tale. The astute tinsmith, familiar with the intricacy of locks in his daily work, noticed the design in the carpet during his prayers. In doing so, he saw
possibilities in the details that the guards failed to
notice, and was able to
escape from his unfortunate situation.
In another context, could the ‘guards’ represent company leaders, investors?
A matter of design I ended a recent post (Aeroplan II and the Rug Seller, Nov 22) with a quote from a Boeing engineer on the day in 1933 when the Boeing 247 was introduced:
“There will never be a bigger aircraft built.” The Boeing 247 turned out to be a commercial failure because of poor design. Only seventy-five were built. It was the Douglas DC3 introduced in 1936 that became the first commercially viable air transport aircraft and launched the U.S. airline industry in a meaningful way, thirty-three years after the Wright Brothers proved powered flight was possible. By the time the U.S. entered WW II, over 800 DC3s were in service. When production ended, over 10,000 DC 3s had been built, including the military version used in the war. While the Boeing 247 only flew into the 1960s as cargo aircraft and personal business aircraft, more than 200 DC3s are still flying today, 84 years after its introduction.
Why did the Douglas DC3 succeed, and the Boeing 247 fail?
Five innovative, but diverse ‘component technologies’, each reinforcing the other, came together to make the DC3 the success that it was.
These component technologies were the variable-pitch propeller, a radial air-cooled engine, a retractable landing gear, a lightweight, all-metal body, and wing flaps. It was the fifth component technology, the wing flaps, that made the DC 3 ‘unique’ among its competitors. Without wing flaps, the Boeing 247 in its
original design was unstable during take-off and landing, so Boeing downsized the engines. Originally planned to carry 14 passengers, the aircraft with smaller engines also had to be re-designed to a smaller, less capable configuration able to carry only 10 passengers. The DC3, on the hand, could carry up to 32 passengers.
Economic Moats
All economic moats are either widening or narrowing – even though you can’t see it.
– Warren Buffet
Popularized by Warren Buffett in the 1990s, economic moats are structural business attributes that help companies generate high returns on capital over an extended period of time.
One of the tenets of economic theory is that competition will erode any competitive advantage a company enjoys. From a financial perspective, this means over time, any company enjoying healthy returns on capital will see its returns fall back to its cost of capital as other competitors enter a market, enticed by high returns.
Morningstar developed and uses an economic moat model in its Ratings Service. The five moats are:
1. Cost Advantage
2. Intangible Assets
3. Efficient Scale
4. Switching Costs
5. Network Effects
Cost Advantage includes both economies of scale and scalability. Intangible Assets are patents, and brands such as BMW, Starbucks, Air Canada, Southwest, etc.
Efficient Scale comes into play when a potential competitor entering the market would have to incur massive upfront infrastructure costs that would create excess capacity in the process, and drive down economic profits of all players. Airports, railroads and pipelines have this economic moat.
Switching Costs are the expenses – time, hassle, money, or risk – a customer would incur to change from one producer or provider to another, even if a competitor is offering a lower price or better performing product or service. Apple is a good example of a company whose customers would suffer switching costs if they changed products.
Network Effect occurs when the
value of a good or service increases for both new and existing users as more customers use that good or service. The network effect is a virtuous cycle that allows strong companies to become even stronger. Examples of companies that have this economic moat are Amazon, E-Bay and credit card companies like Visa and Master Card.
Morningstar classifies companies into wide moats, narrow moats or no moats. If a company can sustain an ROIC greater than its WACC for at least 10 years, then it has a narrow moat. If a company can sustain an ROIC greater than its WACC for at least 20 years, then it has a wide moat.
The Rating Service assigns a wide moat rating to NA railroad companies. In addition to efficient scale, railroad companies enjoy an economic moat rooted in cost advantage. Railroads enjoy roughly quadruple the fuel efficiency of trucking (per ton mile of freight). These economic moats are the bedrock for the higher earnings multiples enjoyed by NA Class 1 Railroad companies. One real threat on the horizon for this industry, however, is driverless electric trucks.
It’s been Morningstar’s practice in their valuations of airlines — even ultra low-cost airlines — to not assign an economic moat. But to paraphrase Buffet, moats are not static, and a company’s competitive position is either improving or declining at any given time. Morningstar in its modelling accounts for this trending and acknowledges that no-moat companies
can be trending toward an economic moat.
Models, however, are always a simplified version of reality and often fail to capture all aspects of a theory. Accordingly, Morningstar acknowledges that companies through a combination of other structural attributes could still form the ‘equivalent’ of an economic moat. An indicator of this situation would be a company that does not meet Morningstar’s criteria for one of its five economic moats, yet has managed to sustain profitability over an extended period to time.
This thinking is supported in McKinsey’s 2015 Travel, Transport and Logistics Review, that companies have been generally quite successful in sustaining ROIC rates. Apparently when companies have found a strategy that creates competitive advantages, they’re often able to sustain and renew these advantages over many years. While competition clearly plays a major role in driving down ROIC, managers can sustain a high rate of return by
anticipating and responding to changes in the environment better than competitors do.
Of course, economic theory did not consider consolidation, alliances and joint ventures as ways to reduce competition; and common ownership and a disciplined ROIC focus as ways to increase profits rather than market share. The mantra today for most airline leaders is profitable growth, not growth for growth’s sake. Thinking about the DC3 analogy, is Air Canada with its ‘component technologies’ trending toward an economic moat or, like the DC3 in the 1930s, does it already have the equivalent of one now, ‘unique’ in its own way?
Using Morningstar’s model, the equivalent ‘component technologies’ for Air Canada are:
- Intangibles, a strong global brand, 2019 Skytrax Awards: Best Airline in North America, Best Business Class in North America, Best Airline Cabin Cleanliness in North American, Best Airline Staff in Canada, World’s Best Business Class Lounge Dining, click on the following link for 2020 awards
- Cost Advantage, scalability, young larger fuel-efficient aircraft, higher employee productivity – available seat miles per employee – than U.S. counterparts, a leisure carrier
- Efficient Scale, privileged Hubs, STAR Alliance member (voted World’s Best Alliance Airline by Skytrax in 2019), strategic Joint Ventures (JVs), more to come
- Network Effect, high value global network with geographic advantage attracting sixth freedom traffic, STAR Alliances and JVs also enhance network value
- Switching Costs, an industry leading program becoming increasingly valuable over time. Number 1 credit card in Canada representing over $1 for every $10 spent on consumer products and services (only program that captures more is the Qantas’ loyalty card)
While the three U.S. legacy carriers offer similar component technologies (to varying degrees),
only one airline has a ‘component technology’ with patent protection that truly differentiates it from the others. Just as wing flaps made the DC3 unique among its competitors giving it a competitive advantage, Air Canada’s geographic advantage, deep global reach and resulting sixth freedom traffic draw make it
unique among
its competitors. So how does Air Canada exploit this
unique competitive advantage in the coming years? Read on.
Accelerating Growth in Loyalty Revenue – An EBITDA/FCF Story
Last month, JPMorgan Chase, the largest co-brand card issuer, and Air Canada announced a strategic partnership that will make Chase the exclusive issuer of the Aeroplan U.S. credit card. Mastercard will become the exclusive payments network for the new offering in the United States. This partnership is noteworthy. It’s the first significant co-brand partnership for JPMorgan in more than ten years.
“The strength of the newly transformed Aeroplan program combined with this partnership will drive significant growth and engagement — focusing on the over 2 million U.S. residents with strong ties on both sides of the border,” said Mark Nasr, Vice President of Loyalty and eCommerce at Air Canada in a written statement."
Most of these Americans are young, global centric and highly-engaged with an affluent skew. As with all younger people, they’re choosing experiences over things. Moreover, many Americans, having a fascination with Asia and Europe, and on learning in transit times from U.S. secondary airports to the two continents through three privileged Canadian hubs, will view Air Canada as a viable travel option.
In previous posts, I commented that Air Canada’s three-year growth target following the acquisition of Aeroplan in January 2019 was to increase membership from five million to seven million by end-2021. Prior to Covid-19, Aeroplan was ahead of schedule in signing up new members.
“We continue to be extremely pleased with Aeroplan's financial results, which once again exceeded our expectations, and continue to contribute meaningfully to our free cash flow. We continue to see strength from our credit card issuing partners, with acquisition and retention results above expectations. Redemptions are stable, healthy and tracked within 1% of our expectations during the third quarter.” Michael Rosseau, CFO, Q3 2019 Earnings Call
The new Aeroplan credit card from Chase is expected to be launched towards the end of 2021. Factoring in growth in U.S. card subscriptions from the over two million American travellers and growth in subscriptions from Air Transat’s customer base (five million passengers carried last year, expecting gains in market share on vacation and European travel H2 2021 and beyond), then in the next two to three years, Aeroplan membership should grow to at least 9 million cardholders.
In my August 30, 2020 post Aeroplan II – 2025 Valuation, I estimated that by end-2025, Aeroplan would have 8.8 million members. This estimate did not consider U.S. loyalty members or Air Transat card holders. Air Canada’s 2019 loyalty revenue was estimated at $1.7 to $1.8 billion. The Airline’s 2025 loyalty revenue was estimated at $4.4 billion. The launch of the USD loyalty card later this year, combined with growth in Air Transat subscriptions will have the effect of advancing the $4.4 billion estimate by at least 12 to 24 months. And of course, with growing loyalty revenue comes expanding EBITDA margins and increasing free cash flows.
For 2022 and beyond, a reasonable assumption is that an increase use of premium economy (higher yielding 6
thfreedom traffic, Aeroplan customers using points to upgrade to P/E) should offset much of the expected temporary drop in business traffic revenue.
Executives at American said the average fare for its premium economy product is twice the coach, or economy, fare, “making it the most profitable use of square footage on our widebody aircraft”. Financial Times, Why airlines are rushing to add premium economy seats, November 29, 2019
And design within a design Competitive advantage depends on offering a unique value proposition delivered by a tailored value chain, involving trade-offs different from those of rivals, and where there is fit among numerous activities that become mutually reinforcing.
– Michael Porter, Harvard Professor
As was the case in the tinsmith tale, the importance of design within design has also been a key theme that Air Canada attended to since the turnaround began more than a decade ago.
Air Canada leadership took a holistic, interwoven approach in attending to and designing its fleet (larger, more fuel-efficient aircraft, optimal fleet mix), cabin configurations (increased seating density, optimal mix of economy/premium economy/business class), capacity and revenue management systems (higher load factors, revenue optimization), fleet financing strategies (fewer leases, major fleet purchase discounts), on-board and off-board products and services (innovative, differentiated, segmented), international network (more diversified, deepened global position, key Alliance, strategic Joint Ventures), sixth freedom strategy (U.S. secondary airports, focus on high yield customers), a leisure carrier (low yield business model) and, importantly, Aeroplan (industry leading agreement, completely redesigned platform, additional member benefits), all of which enables the Airline to escape what Michael Porter calls ‘competitive convergence’, an illness the airline industry has suffered from for most of its history. Porter says a ‘competing to be the best’ mindset leads to competitive convergence and this is the ‘granddaddy of mistakes’ in business strategy.
Porter says the second worst error in strategy is to compete with rivals on the same dimension. WestJet, in repositioning itself, is committing this error – along with poor execution.
Competitive convergence occurs when rivals begin to look alike as one difference after another slowly erodes (boiled frog syndrome?). Customers are left with nothing but price as the basis for choices. Competing to be the ‘best’ comes from a mindset of wanting to be the best, and that leads to intensified competitive rivalry. Many companies go down this path believing they can achieve better results than rivals. Porter says in competing to be the best, imitation is easy, but advantages are temporary. It’s a hard race to win.
Competing to be
unique is the antidote to competitive rivalry. The more a company competes on uniqueness, the less susceptible it is to imitation, and advantages can be sustained over long periods of time. Whereas competing to be the best feeds on imitation, competing to be unique thrives on innovation. This concept is all about
value.
With cost advantage and intangibles easy to grasp, let’s dig down to gain a better understanding of how efficient scale, network effect and switching costs play out in the airline industry and at Air Canada.
Efficient Scale
Toronto, Vancouver and Montreal
Airports meet the efficient scale test, and Air Canada, as the dominant carrier at these airports, indirectly benefits. The hubs’ efficient scale, combined with membership in the STAR Alliance, two Joint Ventures, a third JV on the way (Air New Zealand), and a recently signed strategic cooperation agreement with Qatar Airways, create a formidable barrier to potential entrants. As the dominant carrier in these markets Air Canada is also able to capture a yield premium.
Immunized JVs are partnerships between two or more airlines typically involving collaboration in areas such as schedule coordination and revenue sharing. For travellers, JVs mean seamless travel with more options to the same destination and to a greater number of travel destinations. For airlines, JVs enable them to increase revenue on a number of routes they themselves do not operate. For airlines (and investors), an airline within a JV benefits from less competition and greater pricing power. As of 2016, the three Alliances (STAR, Oneworld and Skyteam) controlled 78 percent of the North Atlantic market.
If you can beat’em, join’em
Until Delta purchased a 49 percent ownership in Virgin Atlantic and formed a JV in 2012, Richard Branson frequently complained that Alliances/JVs were anti-competitive.
Network Effect
The marginal cost to carry one additional passenger is low. Routes with higher density are able to support larger aircraft, which in turn enable lower costs and prices thereby attracting additional customers. It’s this unique attribute that leads to network effect: adding additional connecting flights create not only additional revenues (and costs) on new routes but also enable additional traffic/revenue to be generated for existing connections. These dynamics drive the business model of network airlines, where feeder flights to hubs provide the customers that make larger planes economical to fly on higher-density, longer-haul connections. Hubs are also key drivers of code-sharing, bringing in additional feeder flights operated by other airlines. On specific connections, frequency of service, also a network differentiator, is a
valueenhancer. Airlines offering higher frequencies (e.g. Rapidair) are able to capture more market share.
Air Canada, with its up-gauging program essentially complete, privileged hubs, natural geographic advantage, extensive global network offering both frequency and favourable landing slots (market share) and acquisition of Air Transat, is maximizing the
value of its network.
Switching Costs
The more Air Canada differentiates its offerings (frequency, network, premium products, fleet age, etc.) the more effective its loyalty program becomes. Loyalty programs, beside the loyalty component, also enables the Airline to charge higher prices on connections through its hubs. Loyalty programs have historically only appealed to business class and other high value customers; however, as Aeroplan II’s loyalty cards expand their reach domestically and internationally through increased memberships, particularly among a younger population with a preference to spend discretionary income on experiences rather than on material items
, more loyalty revenue will be generated among infrequent (leisure) travellers.
More on design, and design within a design Total Risk
Over the last ten years, Air Canada saw a significant reduction in both operating and financial leverage. The combination of high operating leverage and high financial leverage has been a curse for airlines, and the key reason for high earnings volatility.
The following link takes you to a post entitled ‘Total Risk’, which gives you a detailed account of Air Canada’s risk profile at the end of 2019.
Air Canada entered this crisis with the lowest total leverage of the NA legacy carriers and with the most liquidity, as a percentage of revenue. An optimally designed capital structure is critical for airlines, an aspect that investors need to attend to.
Future Component Technologies
Just as the DC3 launched the U.S. airline industry in the 1930s, two other component technologies developed in WW II help propel the airline industry to where it is today. The component technologies were the jet engine and radar. Continuing with our analogy, what might be future ‘component technologies’ that will help Air Canada in its continuing effort to differentiate itself among competitors?
Air Canada Cargo – Introduction of Freighters
For sure, one will be Air Canada’s recent decision to enter the all-freighter cargo market, complementing its already healthy revenue stream and margins from cargo carried in the belly-hold of passenger aircraft. In a recent post (Dec 20th), I estimated Air Canada could easily generate an additional quarter billion dollars in cargo revenue by 2023, adding at least $100 million in additional EBITDA.
And it’s not inconceivable the Airline’s ambitions in the cargo arena are much greater than what I’m assuming. With financial flexibility and an already strong foothold in the cargo market, it’s entirely possible Air Canada over the next five years may become the dominant player in the Canadian cargo market, pushing cargo revenue much closer to $2 billion, than the approximately $1.5 billion I estimated. With a conservative operating margin of 40 percent, cargo EBITDA could contribute upwards of 15 percent to the Airline’s total operating margin.
Add to this, Aeroplan II’s expected EBITDA contribution of approximately 50 percent and high margin earnings from its unique sixth freedom traffic, and EBITDA in 2025, both in terms of composition and size, begins to take on a much more resilient dynamic. It would certainly give credence to the case for higher valuation multiples similar to other Industrials (8x to 9x).
Big Data – Driving Incremental Revenue and Increasing Customer Lock-in
From the above discussion on differentiation in product offerings, airline retailing has clearly changed, and can no longer be viewed as a commodity. Big Data is now the buzzword in airline retailing. A disrupter for sure, Big Data is about leveraging data to drive meaningful incremental revenue improvements and increase customer lock-in. Airlines cannot achieve this without having access to passenger data, so that customers’ needs, spending behaviours and decision-making habits can be understood. While many airlines talk about Big Data, few are attending to it as much as Air Canada. Aeroplan II has developed more than a half dozen customer segmentation models that are now used on a regular basis (propensity to upsell, cross-selling, identifying suitable branded fares, etc.)
After acquiring Aeroplan in early 2019, Air Canada spent in excess of $100 million designing the new Aeroplan II platform, removing friction points and enhancing capabilities, pleasing both partner financial institutions and loyalty members. Under Aimia ownership, a substantial amount of capital had already been spent on Aeroplan’s data infrastructure and predictive analytics, and this provided Air Canada with a huge leap forward when it came to integrating Aeroplan’s advanced systems into the airline’s passenger service system and e-commerce database. Combining Air Canada’s non-member database with Aeroplan’s member database created a highly efficient and much more intelligent digital marketing tool able to target core airline and loyalty products.
Global Traveller Magazine awarded Aeroplan the Best Frequent-Flyer Award Redemption for transformed Aeroplan program for 2020.
The link below provides a good overview of how big data is changing the airline business.
For Investors, buyer beware!
The fallout from the Covid-19 crisis is no doubt impacting the airline industry in meaningful ways. Global capacity is falling significantly, and this will push fares higher on the other side of the crisis. Besides survivor airlines’ capacity reductions through parking older, less fuel efficient aircraft, some airlines are undergoing restructuring and will see portions of their newer fleets wiped-out. At one time, Norwegian Air was going to be a formidable competitor against the NA legacy carriers. An airline with a young fleet, Norwegian entered the crisis already in a weakened financial state and a much smaller airline having undergone two restructurings in 2019, the consequence of excessive growth and debt accumulation. Last month the airline launched an emergency rescue plan – after filing for creditor protection – that will see its fleet further downsized. The company’s shares plunged 99 percent in the past year, wiping out previous shareholders.
How many airlines will end up like the Boeing 247, post Covid-19? Many will be struggling just to remain in the air, having entered the crisis ill-designed – over leveraged and not unique in any way. The principles of what to attend to, design and importantly, design within a design will likely not be top of mind on the part of leadership, or even on their mind. The consequence is that these companies will escape this unfortunate crisis ill-prepared for the competitive challenges that lie ahead. Leadership’s mindset will be reactive.
Meanwhile, Leaders of airlines who have demonstrated a creative mindset over time will be able to stay ahead of the airplane and sustain high rates of return for their companies and investors, as McKinsey observed, by anticipating and responding to changes in the environment better than competitors.
The essence of strategy is to find a unique position in your business that delivers unique value to the customers you choose to serve — sounds simple but most companies don't do it.
– Michael Porter