five reasons the airline industry could be...

Auckland

Bangkok

Beijing

Boston

Chicago

London

Los Angeles

Melbourne

Milan

Mumbai

Munich

New Delhi

New York

Paris

San Francisco

Shanghai

Singapore

Sydney

Tokyo

Wroclaw

The materials contained in this document are intended to supplement a discussion at the Massachusetts Institute of Technology on March 12, 2010. These perspectives are confidential and will only be meaningful to those in attendance.

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Five Reasons the Airline Industry Could be Profitable

March 12, 2010

1CONFIDENTIAL

Agenda

L.E.K. Consulting

- Company overview

Introduction to airline industry

Why the airline industry could be profitable

- Ancillary revenue

- Industry consolidation

- Frequent flyer program

- Mitigate downside risk

- Reinvention

Summary

Agenda

2CONFIDENTIAL

L.E.K. Consulting is a leading global strategy consulting firm

Overview

Established in 1983Clients include 25% of the largest 200 companies globally, as well as innovative start-ups and leading private equity firms

Areas of expertise include:StrategyTransaction ServicesFinanceMarketing and SalesOperationsOrganization

Worldwide over 1,000 staff, led by 104 Vice Presidents in 20 offices

Global Network

L.E.K. company overview

TokyoLos Angeles

San Francisco

LondonMunich

Milan

Mumbai

Beijing

Shanghai

Singapore

MelbourneAuckland

Bangkok

Chicago ParisBostonNew York

Sydney

New Delhi

Wroclaw

3CONFIDENTIAL

L.E.K. is the #1 strategic advisor to the aviation industry

Airlines Airports

Other Industry Players

Investors

Aerospace Manufacturers


4CONFIDENTIAL

L.E.K. is at the forefront of all the key strategic moves in the industry

Company Assignment Global News Coverage

Industry-leading Ancillary revenue strategy and implementation

Diagnosis of high-profile irregular operations event

Major strategy review of all aspects of its business

On Time Performance (OTP) Turnaround

World’s largest airline merger

Frequent Flyer program spinoff analysis

Maintenance division spinoff analysis

Support for acquisition of ACTS (MRO division)

Major Global Airline

Blue Chip PE Investor


5CONFIDENTIAL

Agenda

L.E.K. Consulting

- Company overview

Introduction


- Ancillary revenue




- Reinvention

Summary

Agenda

6CONFIDENTIAL

Note: *This deficit includes only international airports

Average Annual Global Economic Surplus and Profit Distribution across the Air Travel Value Chain (2003-2007):

Net Deficit:$4B

Net Surplus:$567B

(U.S. = $197B)

Net Surplus:$1B

Net Surplus:$8B

(U.S. = $3B)

Net Deficit:$8B

(U.S. = $5B)

Net Deficit:$1B*

Net Surplus:N/A

AirlineAirport

Customer

Society

GovernmentDownstreamParticipants

Labor

ExternalFactor Cost

While the airline industry generates an economic deficit, others in the travel eco-system such as government, customers, and labor are significant beneficiaries

Introduction

7CONFIDENTIALNote: * Top 5, excluding airlines with fewer than 8 years of data

Source: CapIQ, Compustat, L.E.K. analysis

However, over the past 10 years there have been successful airlines that have generated significant shareholder value

$11.6B$201M

$3.8B$204M

$32.7B$212M

$9.9B$84M

$9.7B$69M

10-Year Average Annual NOPATLess Capital Charge 2007 Total Revenue“Winning” Airlines*

Top 5 Airlines by 10-yr Average Annual NOPAT Less Capital Charge

Introduction

8CONFIDENTIAL

Agenda

L.E.K. Consulting

- Company overview

Introduction


- Ancillary revenue




- Reinvention

Summary

Agenda

9CONFIDENTIAL

Due to price transparency and intense competition, airlines have very limited ability to capture higher yields by increasing published fares

(2.1)%

(1.2)%(1.0)%

(1.0)

0.0

(2.0)

(3.0)

Source: APGDat, Online survey of consumer marketing panel using average published fare of $354, L.E.K. analysis

Airlines generally cannot raise prices without losing revenue and market share; other revenue opportunities are essential

Ancillary revenue

Estimated revenue impact of higher fares for a leading U.S. carrier% impact on total revenue

Published fare Published fare +$10Published fare + $5Published fare +$2 Illustrative

10CONFIDENTIAL

Ancillary Revenue streams, such as baggage fees, have enormous ROI and rapid payback

Source: L.E.K. analysis

100x ROI in first 12 months post-launch of an “unbundling”strategy for a Legacy

140x ROI in first 12 months post-launch of an “enhancement”strategy for an LCC

A L.E.K. engagement resulted in project pay-back within three days of launch

In addition, the incremental annual profit from one single “launch initiative” was US$70m

Key Benefits of Ancillary Revenue

High Margin Low InvestmentRequired

Not CompetedAwayQuick Uptake

High ROI Rapid Payback

Ancillary revenue

11CONFIDENTIAL

10

303040

5050

758085

90959595

0

20

40

60

80

100

Bag Fees FF Mile Reduction

Seat Select

A B C D E F W X Y Z

Margins for Select Ancillary Revenue Products (Blinded)Percent

Basic ProductUnbundling

Premium Product Unbundling& Enhancements

3rd Party ProductEnhancements

Source: Company financials, Press releases, L.E.K. analysis

Illustrative

And its not all about takeaways…products and services that enhance the customer experience, while not as high margin, still have very healthy economics

Ancillary revenue

12CONFIDENTIAL

Off-vesselRepackaged B2C

Airport Lounge Packages

Family Traveler Packages

Child Traveler Packages

Business Traveler Packages

Core Product

Enhanced Mix of B2C & B2B

“Window Shopping”(On-line stores)

On-line Gambling

2

2

22

446

7

41

4

6

Enhanced B2C

Internet On-Board

In-Flight Entertainment

Food/Beverage On-Board

Upscale Amenity Packs

2

22

554

5

Core B2B

IFE/Web Advertising

5Core B2C

Baggage Fees

Booking over the Phone

Confirmed Seat Assignment

Fee to Stand by

Ticketing Fees

Miles Rationalization

Unaccompanied Minor

2

2

11

1

67

1

1

3

Experience Packages

1 Product2 Flight Experience

4 Airport Experience

6 Mileage and Status7 Customer Service

5

3 B2B

B2CB2B

Enhanced B2B

Enhanced Advertising

Consumer Trials33

Enhanced B2C

Premium Seating*

Lounge Access

Priority Baggage

Priority Security

Priority Check In and Boarding

Elite Status a la carte

Mileage Purchase

Trip Protection Insurance

Repackaged B2C

Subscription Services for Amenities

FF Gaming Bundles

Entertainment Packages

Enhanced B2B

Vacation Packages 2.0

On-vesselOff-vesselOn-vessel

Core B2B

Traditional Advertising

Hotel Partnerships

Mileage Redemption

Rental Cars

Financial Services

6

7

3

7

3

High Realization

Low Realization

Current Implementation

Merchandising represents a ‘game-changing’ opportunity for the airline industry that is still in its infancy but requires a fundamental shift in the mindset and skills deployed by the industry

Illustrative

Ancillary revenue

13CONFIDENTIAL

L.E.K. expects ancillary revenues to continue to transform the airline industry in the coming years

Source: Company financials, press releases, L.E.K. analysis

Product Unbundling

Phase

Product Enhancement

Phase

Repackage / Rebundle

Phase

B2B Phase

Sample Products 2014 Revenue Expectation

Baggage fees

Seat selection

Booking fees

Internet on-board

Lounge Access

Priority security

Entertainment package

Business traveler package

Luxury vacationer package

On-board retail

Surveys

Focus groups

~$6B - $7B

~$2B - $3B

~$1B - $2B

~$2B - $3BNon-

customer focused

initiatives

$40B - $50Bof high-margin

revenue

~$23B - $26B

~$7B - $9B

~$4B - $6B

~$6B - $8B

U.S. Global

Ancillary revenue

14CONFIDENTIAL

But for the airline industry to fully realize the benefits of ancillary revenue it must embrace the merchandising prowess of other industries

Retail Media & EntertainmentBranded ConsumerAirlines

Ancillary revenue

15CONFIDENTIAL

Agenda

L.E.K. Consulting

- Company overview

Introduction


- Ancillary revenue




- Reinvention

Summary

Agenda

16CONFIDENTIAL

Motivation Actual Result

America West –U.S. Airways

Northwest – Republic Combination of two route systems with significant overlap could eliminate competition

Rapid operations and workforce integration lead to operating problems

Solidified Minneapolis, Detroit, and Memphis as key Northwest hubs

Addition of west coast hubs to Delta’s already-strong east coast system

Delta’s operations still remain concentrated on the east coast

Rescue TWA’s valuable international routes

Competition reduced and TWA’s assets acquired at a discounted value

Annual revenue and cost synergies of approximately $600 million

Optimization of the merged route system

Expected cost and revenue synergies of over $1 billion annually by 2012

Source: Cathay Financial, Company financials, L.E.K. analysis

1986

1986

2001

2005

2008

1989

Key Pairings

Delta – Northwest

American – TWA

Delta – Western

DOJ establishes stringent antitrustreviews

Marks the transition of merger motivations from primarily eliminating competition to optimizing networks and reducing costs

Being a high fixed cost industry, the airline industry benefits from scale through acquisition just like any other high fixed cost industry

Industry consolidation

Delta has announced that steady state synergies are now expected to be $2 billion annually by 2012

17CONFIDENTIAL

Source: Company financials, L.E.K. analysis

3.30.4

0.30.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

Cost RationalizationFleet optimization Network Presence "New" Delta Operating Income

L.E.K. analysis of the financial impact of Delta / Northwest merger$billions

2.2

NW

DL

2007 Operating Income

Estimated Annual Benefits of DL+NW Combination

L.E.K. took a conservative approach to its strategic support of the Delta/Northwest deal; Delta has since increased anticipated benefits to $2B+


Delta is now the largest market cap airline in the US, second in the world – clearly a sign that the financial markets believe in the benefits of consolidation

18CONFIDENTIAL


0

20

40

60

80

100

BAEKWN

AA

UA / CO / LH / AC

DL / AF-KLM

ACQF

USBAEKWNLH

AA

AF-KLM

UA / CO

DL

Current

ACUSBAEKWNLH

CO

UA

AA

AF-KLM

DL

Share of worldwide RPKs for top 20 airlines(1/2009 – 11/2009)Percent

SQCXQFUS

Other Top 20Other Top 20

Other Top 20

Airlines’ long-term strategies should prepare for mega-carriers, which are already being “created” in the $20B+ DL / AF TATL joint venture

Source: ATWIncreasing Consolidation

For scale to be sufficient to enable a US carrier to generate sustainable economic returns, L.E.K. has calculated that it needs to be greater than ~$40bn in annual revenues – roughly

equivalent to the merger of three traditional legacy carriers

19CONFIDENTIAL

Agenda

L.E.K. Consulting

- Company overview

Introduction


- Ancillary revenue




- Reinvention

Summary

Agenda

20CONFIDENTIAL

Greater Transparency /More AccurateBusiness-line

Valuations

Greater Transparency /More AccurateBusiness-line

Valuations

Sophisticated CRM/Direct Marketing Focused

Management

Sophisticated CRM/Direct Marketing Focused

Management+

Historically, a highly effective affinity mechanism with a largeattractive demographic

Historically, a highly effective affinity mechanism with a largeattractive demographic

Eliminates / LessensConglomerate DiscountEliminates / Lessens

Conglomerate Discount

Significant Value Creation

Value can be created by separating loyalty programs from their parent airlines

Frequent flyer program

21CONFIDENTIAL

Since its IPO, Aeroplan gross billings growth has been driven primary by credit card partners and by acquisitions

Notes: Forecasted gross billings according to Raymond James Ltd. company reportsSource: Aeroplan Company Financials, Analyst Reports, L.E.K. Analysis

0

500

1,000

1,500

2,000

1,491

2009F

1,392

2008

1,421

2007

952

2006

852

2005

755

1,585

Gross Billings: Aeroplan Gross Billings by Partner (2005-2008)$millions

2011F2010F

Air CanadaCIBCAmexOther - Canada

Other - ex CanadaSainsbury

CAGR%(2005-08)

11

2

28

6

11

23N/A

N/A

CAGR%(2005-08) (2009-11)

Total - Group

Organic Growth(Canada)

Inorganic Growth(ex Canada) N/A

6

7

8


22CONFIDENTIAL

Agenda

L.E.K. Consulting

- Company overview

Introduction


- Ancillary revenue




- Reinvention

Summary

Agenda

23CONFIDENTIAL

In order to reduce the fixed costs associated with capacity reductions due to parking of aircraft or lower utilization, airlines pursue strategies to make fleets more flexible, including:

- Leasing aircraft on a consistent basis over time, so that the fleet fluctuates with capacity on an annual basis at a low cost (e.g. for its long haul fleet LAN has lease renewal options representing ~10% of passenger capacity annually),

- Use of aircraft with low ownership cost, such as Northwest/Delta’s continued use of DC9s

Mitigate downside risk

The airline industry is highly cyclical; airlines will continue to develop new strategies to mitigate downside risk

LAN airlines long haul fleet planning strategy (2007 - 18F)Aircraft

0

10

20

30

40

50

60

70

Low Case

Base Case

07 17F08 09F 10F 11F 12F 13F 14F 15F 16F 18F

Illustrative

Source: Company annual reports, L.E.K. analysis

24CONFIDENTIAL

Another way of mitigating the downside risk is to ensure that your cost base is structurally sustainable

Manage factor costs so that you remain competitive versus potential disruptors in the industry e.g. labor costs. Singapore Airlines probably best example here:

- Flight Attendants on 5 year contract that is only renewal on promotion to higher levels

- Flight Crew composed of percentage of ex-pats on expat “fixed rate” contracts without tenure escalation clauses

Factor Costs


25CONFIDENTIAL

Agenda

L.E.K. Consulting

- Company overview

Introduction


- Ancillary revenue




- Reinvention

Summary

Agenda

26CONFIDENTIALNotes: *Includes regional carriers; **L.E.K. static forecast

Source: Form 41, CapitalIQ, BEA, CBO, L.E.K. analysis

The 9/11 terrorist attacks led to a permanent dislocation in the relationship of air revenue to GDP and the current recession is likely to do the same

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1.00

U.S. carrier passenger revenue to GDP ratio (1991-20F)Percentage

06 08 10 12 14 16 18 20

Forecast**

92 94 96 98 00 02 04

9/11 terrorist attacks and recession

The combination of a global recession and improved video-conferencing technology could

produce a 2nd permanent dislocation

Legacy only

All (including LCCs)

Reinvention

27CONFIDENTIAL

Note: All entities without ownership stake specified are fully owned *Lufthansa announced plans to acquire a majority stake in Austrian Airlines and Brussels Airlines in 2008; ** Current 30% share to increase to 80% pending approval by the EU CommissionSource: Company websites and annual reports, L.E.K. analysis

Operational Support

Travel / Touring

49% Stake

49% Stake

56% Stake

25% Stake51% Stake

20% Stake

81% Stake

Long-Haul Shuttle Economy

Singapore Airlines Ltd

Supporting

Code-share partners

Cargo

Airlines have successfully reinvented themselves by creating portfolios of companies to serve distinct customer segments; this reduces the threat of a competitor capturing an underserved segment and then expanding

Operational Support

Divested

Long-Haul* Shuttle Economy Supporting

Lufthansa Group

80% Stake**

19% Stake

Cargo

Travel / Touring

50% Stake

80% Stake**

Reinvention

28CONFIDENTIAL

Characteristics of a Successful Portfolio Airline

• Separate clear and distinct brands

• Independent operations and management

• Separate cost base

• Separate labor arrangements

• Fleet optimized

• Free to compete with one another

For Each Service Offering:

• Tailored product

• Unique value propositions

• Overlapping network to allow optimized coverage of target segments

For Each Customer Segment:

Source: L.E.K. analysis

Reinvention

Implementing a reinvention effort such as a successful portfolio strategy requires separate cost structures, distinct brands, and clear segmentation

29CONFIDENTIAL

Agenda

L.E.K. Consulting

- Company overview

Introduction


- Ancillary revenue




- Reinvention

Summary

Agenda

30CONFIDENTIAL

So if it was that easy, why isn’t the industry more profitable?

Well, there are financially successful airlines

The industry is full of optimists …. how many airlines’ 5 year plans incorporate the inevitable “black swan” events?

How many airlines have the rigorous contingency plans for the downturn?

Given the high fixed cost nature of the business its all about minimizing the down side so that it doesn’t swamp the upside

More than any other industry because the barriers to entry are so low its all about planning for change and being able to re-invent yourself… but how to do so in the constraints imposed by government and labor

Summary

Its hard but certainly not impossible

31CONFIDENTIAL

5 reasons why the airline industry could be profitable

Summary

Ancillary revenue




Reinvention5

4

1

2

3

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