The difficult space that is the airline industry
11 April 2016
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Hello and welcome to another edition of Old Mutual Live Business, my name is Chris Gibbons. In this edition we exam aviation, what exactly does it take to run an airline? I spoke to the CEO of Comair, one of South Africa’s most successful independent airlines, Eric Venter. I began by asking Eric what makes airlines so difficult to run and that’s generally internationally, around the world, not just in South Africa.
Eric Venter: One of the challenges has been the legacy of state owned airlines. The fact that slowly but surely private sector has come in. This is not only in South Africa, in many countries around the world. As soon as you have a private sector competitor trying to compete with a state owned legacy enterprise, you always have this clash between entrepreneurial approach of the private sector and, the funding from the private sector versus typically a very staid government run organisation as a competitor.
Very little accountability in that competitor because of the fact they typically have almost unlimited resources or at least they don’t ever have this threat of bankruptcy. So, you tend to find that imbalance between a state run airline trying to survive against private sector, which has to take much more aggressive stance to remain in business against a state owned carrier.
It creates this depressed profit margin environment. If you consider how capital intensive aviation is, it should be generating pretty substantial returns. Because of the amount of capital invested in the business. If you’re sitting with, globally, there’s something like three trillion dollars’ worth of aircraft. Yet in the medium term, over an average 10 year rolling cycle, the profit, aggregated profit, is typically zero.
I can’t think of many industries that have probably destroyed as much equity as aviation. Until the aviation globally is rid of this legacy of state intervention as direct competitor, it’s going to be very difficult for the industry to actually achieve an equitable environment. Where entrepreneurial effort actually deliver the kind of returns that they should deliver.
South Africa is a prime example of the struggle
CG: And South Africa is a particularly good example of that?
EV: Absolutely. South Africa, the airspace was deregulated in 1990. There was specific policy created to actually encourage the private sector into the aviation industry at that point in time. It included a lot of restrictions that were placed on SAA within this policy.
For example, there was a clause in the policy saying that SAA will not be supported financially by government in any form, as long as the private sector airlines have to raise their own funding. Then there were a whole lot of provisions around anti-competitive behaviour of SAA etc. But really, none of that has been adhered to whatsoever.
So, initially in the first few years, the first airlines that popped up, the Flight Star, Phoenix, Sun Air, they were actually just blatantly bought by SAA and shut down. Once it got to the shutting down of Sun Air, then government perked up and said, no, this isn’t actually acceptable practice, to get rid of competition.
Since then it’s been more of a case of real anti-competitive dominant carrier type conduct, or alternatively, when costs rise, SAA simply kept their airfares at an unsustainable level for other carriers. So we saw, going back to 2002/03, when we saw that massive spike in exchange rates, we saw a few carriers disappear at that stage already.
Then we got the 2008 spike in the fuel price, Nationwide disappeared because SAA didn’t put airfares up. We saw with 2011, again with the rise in the fuel price, Velvet Sky and One Time went out of the market because SAA wouldn’t put up the airfares.
So it’s really just become a case of, when you’ve got this assurance of not going bankrupt, you don’t have to worry too much about your commercial practices. You can rather focus on getting rid of the competitors and that’s the crux of the problem with having, what would we call it, ‘immune’ competitors.
Talking about it, it’s not unique to aviation, it’s not unique in South Africa. There are other environments where the same kind of situation occurs. For example, a strange example, I was speaking to someone involved in the, what do we call it, pharmaceuticals consumables industry. Making toilet paper and soap and all of these things.
Their biggest competitor has just decided to include Africa and the Middle East and Europe into a single geographic region for their global business. All of a sudden this local producer has got their biggest competitor being subsidised by their sales in Europe and the Middle East.
It happens in all forms and shapes; it doesn’t necessarily have to be government that causes this kind of anti-competitive environment. It can also be achieved in the private sector, through cross-subsidisation. Yes, talking about trying to clean up the aviation industry, certainly there’s still a way to go before we can really see the benefits of private sector initiative in aviation.
Comair keeping the family spirit alive
CG: Let’s talk about Comair, it is something of a family company. It originated that way, does that present special challenges to management?
EV: It was, until a few years ago it was still, I think with the family that was originally involved. It was still sort of perceived by them as being the family business, even though it was listed on the JSE. I think over the last few years that’s been cleared out pretty well.
Culturally, we still make a lot of effort to try and keep it a family type business. But more about the Comair employees as being the family as opposed to the specific owners or shareholders in the company being the family. We’re still trying to keep the culture of a small business despite the growth and the size of the company over the years.
CG: You also have a very close relationship with British Airways, they’re a shareholder and Comair holds British Airways franchise, how do you manage that relationship?
EV: Fortunately, they’re about 11 hours away by aircraft. So that has its benefits in various forms. Firstly, we don’t overlap on their operational territory. They had about 11 franchises at one stage, but most of them were in Europe and they actually overlapped on BA’s own doorstep. Now they’re down to two, which is us in South Africa and Sun Air in Scandinavia.
Then the second benefit, of course, with them being 11 hours away is that they’re not always looking over our shoulder. We can get on with running the business, as we wish to do. We do run it entirely independently of them, it’s really just a branding relationship. There’s not too much that we really need to deal with on a day to day basis. As long as we are upholding the brand values, we can get on with running the business.
Establishing a low-cost carrier
CG: Talking of brands, a particular success has been Kulula.com, where did that idea come from and how difficult was it to establish it?
EV: Well, low-cost airlines had been around for quite a while before Kulula. Going way back you had the South West Airlines, Rhiner had already established itself by the time Kulula launched. So there were a lot of other carriers to model Kulula on.
We didn’t have to come up with a completely new concept. But we did see that, at the time there was a lot of interest in South Africa. Richard Branson around Virgin Active gyms and all kinds of bits and pieces and we started hearing rumours about Virgin coming in to start a low cost airline in South Africa.
We thought well, we’d better beat them to it and so approximately four months after we’d come up with the first or had the first meeting on establishing a low-cost carrier, we launched Kulula. It was quite a quick process. Fortunately, we already had a complete airline operation to use as a backbone for the launch of Kulula.
So it wasn’t that difficult and in those days, the environment was quite different around the ability to use older aircraft. You didn’t have to worry too much about operating costs, you had to worry more about the fixed cost of aircraft whereas today that’s completely reversed.
The distribution channels in the market were much more simple. The consumer behaviour was much more simple. There was no social media. The whole environment for launching an airline was actually very much easier than it would be today. So, it wasn’t that hard. It was a lot of work, but in the end it wasn’t that difficult really.
Keeping staff morale high
CG: Now, to many people, working for an airline can seem like a very glamorous job, especially for your air crew. But the reality, I think, means long, hard hours, cramped conditions, working with members of the public, some of whom can be deeply unpleasant at times. How do you manage those teams, especially those on Kulula who nearly always seem to be upbeat and smiling?
EV: Well, we’re very, as I mentioned earlier, we’re still trying to keep this family culture within the company. Our philosophy is very much driven by, your staff will only look after the customer to the same extent that you look after your staff. Everything really starts with trying to do the best that’s practically possible for our staff.
So we do put a huge amount of effort into company culture. I believe there’s three components to the business; the equipment, the skills and the culture. Interesting enough, the first piece, which is the equipment, is actually the easiest piece to deal with. Yet most businesses put the most effort into the equipment.
The second most difficult part is the skills and typically there’s still a lot of effort to put in there. But not to the same extent as the equipment. Then people tend to kind of leave the culture behind and say, we’ll put out a statement of corporate conduct and that’ll be our culture. We found that the hardest part is really maintaining the culture.
It involves a huge amount of work, but at the end of the day it is the biggest differentiator for us in competing. In a service industry, the corporate culture is everything. So that, to a large extent, I think has been our factor in staying in business and being effective as a competitor.
Managing fluctuating business costs
CG: Eric, the past couple of years has seen a staggeringly high oil price, was there a point when you thought this would kill the airline. That must have put immense pressure, not only on you, but on your line managers.
EV: In fact, since we started upgrading the fleet, very aggressively in about 2011, we’ve actually made the most profit at times when the oil price is the highest. Because we’ve created such a gap in operating efficiency between ourselves and other competitors.
Because of the new fleet, that in an environment of high oil prices, everyone needs to get their airfares up. Because of our new fleet, because of the operating efficiency of that fleet, when we’re still selling a competitive airfare, we’ve actually got a bigger margin in terms of efficiency than what they have got.
In 2012/13 when the oil price was really at its peak or the rand fuel price rather was at its peak, that’s when we were making our peak profits. Which is very counter-intuitive and it’s not necessarily that it has to be that way. But with that level of efficiency in the new aircraft, it does actually create a huge buffer for us and a real mitigate to a high oil price.
CG: So now the oil price has come down, how do things change?
EV: Not really, one just has to re-shuffle the business a little bit. I think the analogy quite often used is a bit like Master Chef. Every year you get your mystery box of ingredients and you have to figure out, what’s the best dish you can make with these ingredients.
We certainly don’t have the luxury of simply increasing airfares when we want to. We’ve seen globally that the cost of air travel in real terms has come down by 70% since air travel really took off just after WWII. We see the same thing in South Africa.
We’ve done quite a lot of benchmarking, particularly back to 2001 with the launch of Kulula. The average airfare, domestically in the South African market has only increased by 25% over that period. While the consumer price increase has been around 100% and airline inflation, cost inflation has been over 200%.
Every year you have to find a way to close the gap between that cumulative 200% inflation that’s occurred over the period and 25% increase in airfares. Yes, the new aircraft allow you to do that, but whether the oil price is high or the oil price is low or the exchange rate is high or the exchange rate is low; every year you’re faced with that same challenge of saying, how do we actually make it work this year.
CG: How do you manage the customer expectations that say: oil price is down, therefore ticket prices must come down?
EV: Typically, they do pretty quickly, even at the point in time when there was only, in the low-cost market, only Kulula and Mango. There was still incredibly aggressive price competition going at the time. The moment the oil price came down you saw the airfares coming down, just as a result of good competition in the market. There isn’t really scope to sit back and achieve any kind of super profit.
Whether the oil price is high or the oil price is low. Just the simple requirement to keep filling up those seats on the aircraft means that the pricing is always aggressive and does tend to follow the cost structure that the airlines are facing at that point in time.
Where are we going as an industry?
CG: If you look ahead, how do you see South Africa’s airline landscape developing, what are the key challenges going forward?
EV: I think some of the real challenges that we’re facing now revolve more around the skills in the regulatory bodies. The skills in the state-owned service providers to the aviation industry. It is an extremely, highly regulated industry. It does require some very strong experience in dealing with that regulation.
Because there are so many components to the regulation, around safety, around maintenance, around the psychological behaviour of aircraft crew. Around the technical training of aircraft crew and technicians etc. All of these things have to be seen in a single high level picture.
The problem that we have in South Africa at the moment is a lot of those very experienced regulators have left the industry. So we have a new lot of regulators that are all specialists in particular areas. But you don’t find many that actually understand the bigger picture.
Very often when something happens in one aspect of aviation, they simply shut the doors and say, this has to be dealt with in a particular way. Not considering all the other aspects of regulation and the other safety aspects and complications that come with it. That can result in some very severe knee-jerk requirements from the airlines to try and fix things. In a way that’s not actually optimal to operating the business in the aviation industry.
We’re hoping that that level of expertise will build again in the airports company, in the air traffic control, in the civil aviation authority etc. Because you can’t just work on a tick box approach to these things, you have to really understand the consequences. You have to understand the alternative ways of dealing with regulations and with safety issues. It’s a matter of building experience again. It’s a bit unfortunate that the approach has been taken by government, it has actually driven out a lot of the experience.
CG: Eric, final question and it’s one slightly off topic as it were. You’ve just launched or you’re about to launch a scheduled flight under the BA brand to St Helena, and I think also Ascension Island, both tiny specs in the middle of the Atlantic. It sounds very exciting, but is that really viable from a business point of view?
EV: Not at all! In fact, if someone came to us and said, we’ve got this great opportunity for you to sell tickets to fly to St Helena, we wouldn’t touch it with a barge pole. But it’s part of a much bigger picture for the British government around trying to create financial independence for St Helena island.
It also came at a time when they’d either have to replace the existing ship, which was getting very old or find an alternative method of connecting to the rest of the world. So the revenue on those flights, there’s a level of guarantee from the British government on the revenue level on those flights. Which is the only thing which makes it viable to even consider operating those flights.
CG: Understood. Eric Venter, CEO of Comair, thank you for being with me.
EV: It was a pleasure.