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The arduous task of turning the national carrier around

10 Dec 2015 - {{hitsCtrl.values.hits}}

Prime Minister Ranil Wickremesinghe had clearly enunciated in his economic policy framework that all state-owned enterprises (SOEs) would be brought under a State Holding Corporation (SHCL) and operated as a trust. He had further said these SOEs would take meaningful steps to incorporate private sector-style efficiency measures that would ensure them being run efficiently.

Policy framework
This clear policy statement is reflected in the Budget of 2016 when Finance Minister Ravi Karunanayake promised: “We will restructure and reposition SriLankan Airlines with professional management inclusive of local and foreign experts” as it is at the moment, one of the top five SOEs bleeding this economy for the past several years. Debt of SriLankan stands at Rs.158 billion, of which 72 percent had been incurred during the last three years, possibly due to the re-fleeting plan and acquisition of new livery.

With this article, I expect to take the informed readers briefly through a diagnostic, restructure and re-orientation path, which perhaps the management team at SriLankan needs to take positively.

Interestingly, a leading consultancy (Mc Kinsey & Co, 2014) prescribes the following indicators to diagnose a distressed company: (1) They believe in their experience, that not all managers entrusted with change are incompetent but often work under a set of paradigms which are no longer applicable or (2) the management team is looking at the wrong data and still (3) others are caught up in the pressure for short-term returns and often sacrifice the long-term health of the company.

Diagnosis
Each day airlines reach the remarkable feat of moving five million people more than 40 million air miles around the world safely but often fail to deliver on the ordinary. The aircraft once on ground taxi to a jetway wait for ground crew to open the door or for end of the traffic caused by another plane’s maintenance delay. Even low-cost carriers (LCC) or budget airlines lose bags, keep valuable employees idle, depart late and tie up billions of rupees/dollars in ‘underutilised’ aircraft and ground handling or engineering equipment.

In a another industry, the firm will work through such asset utilisation issues and deliver their service/product at low cost, high quality to retain satisfied customers. Airlines, particularly network airlines (NWAs), historically have focussed on safety, aircraft technology, speed, geographical reach and in-flight service attributes. On top of this, regulatory compliance of IATA and other local civil aviation authorities and the unpredictability of weather (example of what went on at Chennai Airport during the last few days) take their toll.

These constraints compete with an airline’s ability to restructure routes, manage excess capacity, price their seats competitively, manage yields and maintain engineering excellence. As a result, these issues exert pressure on management teams and the airline does not find itself comfortable with precision planning to be ‘operationally efficient’. The same consultancy cited above had found that over 45 percent of an airline’s cost structure consists of maintenance, ground handling, in-flight services and aircraft acquisitions or replacements (outside the cost of aviation fuel).

Cost efficiency
Cost efficiency is critical for an airline’s ability to compete. However, this does not mean that every airline should seek to be the lowest cost operator.

Instead, it is important that the costs appropriate for the standard of service provided to the customer are achieved in the most efficient manner.

Strong competition from LCCs has forced the NWAs to respond or to fail. The strategic response can take many forms, but all involve improving ‘cost efficiency’ – a process given even more urgency because of the significant rise in jet fuel costs. However, while there are several lessons on cost efficiency to learn from the LCCs it does not mean that NWAs must adopt their business model wholesale. Airlines offering additional services, for which their target customer base is willing to pay, will incur higher costs; the key is ensuring that these costs are delivered efficiently and economically relative to the premium in yields that higher service quality can attract.

For example, SriLankan engaged ‘Inter Vistas’, an airline consultancy, in 2012 to reduce direct distribution costs as well as achieving turnover in ‘higher yield passengers’. This business model is being adopted at present with a new distribution mix to reap cost advantages. One needs to remember that such targeted strategies (alone) will not yield the economies of scale required in a major turnaround, that too in an airline with a ‘heavy debt burden’ and possibly cash management issues.

Cost gap
Another element of this diagnosis is the cost gap in terms of operating costs per available seat kilometre (ASK). When one asks someone travelling to Asia what airline they wish to fly, they’ll say Singapore Airlines (SQ). Because they know that airline is famous and the basis of that fame is their ‘service’. In this industry, ‘image is everything’ and that image is created by the service that is delivered. SQ can stand its own against LCCs in the region. SQ’s rival ‘AirAsia’ in the LCC category in contrast enjoys substantial low-cost infrastructure and distribution costs.

Once, when AirAsia CEO Tony Fernandes was asked by the former Malaysian Prime Minister Dr. Mahathir Mohamed why he should grant Air Service licence to AirAsia over SQ, Tony shared with the audience in Colombo (at a CIMA conference) that he told the premier that ‘you can have twice the fun at half the price’. The basis of his boast is AirAsia poster showing four stewardesses pointing to the sky as against the typical two stewardesses shown in SQ posters. The premier had burst out laughing and Tony got his licence.

LCCs have developed large cost advantages over the NWAs in both Asia and rest of the world. An IATA study revealed in 2004 that the unit cost gap between AirAsia and a relevant network carrier was 68 percent. AirAsia is an extremely low-cost airline. Its very high aircraft utilisation – with average aircraft block hours per day more than 50 percent higher than the network airline – helps to reduce operational unit costs, while its use of secondary airports significantly lowers infrastructure costs.

Network airlines in these regions are in the early stages of responding to the challenges posed by LCCs. They are characterised by the following:

Primarily operate point-to-point.
Serving short-haul routes, often to/from regional or secondary airports.
A strong focus on price sensitive traffic, mostly leisure passengers.
Typically one service class only, with no (or limited) customer loyalty programmes.
Limited passenger services, with additional charges for some services (e.g. on-board catering).
Low average fares, with a strong focus on price competition.
Different fares offered, related to aircraft load factors and/or length of time before departure.
A very high proportion of bookings made through the Internet.
High aircraft utilisation rates, with short turnaround times between operations.
A fleet consisting of just one or two types of aircraft.
A simple management and overhead structure with a lean strategic decision-making process.

The cost advantages (cost gap) drove AirAsia’s efficiency from 41 percent in 2002 (i.e. AirAsia’s unit costs were 59 percent of those of the network airlines) to 68 percent in 2004 (i.e. AirAsia’s unit costs were 32 percent of those of the network airlines) for example.

The other features of the cost advantage were:

Though AirAsia has very low labour costs, it accounted for only a small proportion of the overall cost gap with the network airlines.
Aircraft ownership and operational costs account for around a third of the difference. AirAsia’s fleet is almost all leased, with a high average age, but its average aircraft utilisation per day is over 12 hours, over 50 percent higher than the network airline.
There are also significant differences in infrastructure costs. AirAsia route strategy makes substantial use of secondary airports that help to reduce airport and ground handling costs.

As with other LCCs, AirAsia also retains a sizeable cost gap in product, distribution and overhead costs with substantially lower ticketing, promotion and sales costs.

The above analysis provides the turnaround team, targets to hit in their turnaround journey.

Under performance
SriLankan defies the typical dichotomy which some analysts have come up with. Airlines which fail are either:

Those that have fallen behind and are at risk of failure needing to focus on regaining customer trust and loyalty, and restructuring route networks, business processes and costs in an ‘improvement and innovation’ reorienting approach.

They are underperforming airlines, challenged by decline in traditional markets and recognise that opportunities exist elsewhere, focus on product and service development. Look to possible new/underserved frequencies/routes in a geographical growth, deploying ‘extension and expansion’ reorienting approach.

The history of the airline (as was explained in my last article) was chequered. Political overtones came to displace managerial wisdom as it was the case when the very competent board headed by ex DCA Laxman de Mel and an equally strong CEO (John Fleming ex SAS) were displaced in 1989/90 by Dunstan Jayawardena and a CEO who found political favour in his appointment. To some extent SriLankan falls under the ‘second category’, where misaligned policies aggravated by a global decline in airline markets and rising costs of aviation fuel found the national carrier doddering.

Decline
Decline in business of an airline has been defined as ‘k-type’ and ‘r-type’. The former stems from industry decline, when organisations have exhausted their environmental resources or other organisations have begun competing for limited resources as when there is severe market share erosion or a shrinking market and shrinking financial resources.

The latter is more ‘internally induced’ and occurs when a company does not fulfil its potential and becomes uncompetitive due to strategic misalignment with its environment. Most analysts agree that the overwhelming cause of individual airline (or any other business) failures is some type of managerial incompetence. Strategic misalignment can see a company falling out of sync with its environment, often as a result of top management decisions to undertake ill-advised expansion, or their failure to update product lines, overcome functional weaknesses and curtail operating expenses. This can generally be seen as the case with SriLankan.

While a substantial amount of declines were due to efficiency reasons, turnarounds were often found to be associated with strategic moves and share increasing strategies.

Turnaround
Those airlines, which had a greater capacity for strategic change, had their CEOs replaced, slack resources made available, often common among larger NWAs. However, the threat of rigidity, which is frequently associated with decline and turnaround situations, needs to be navigated with caution. Airline companies become dependent on formalized and overly standardized operating procedures that have proved effective in the past. Such mechanistic structure shifts can reduce a company’s adaptive capabilities and these are most likely to occur in turnarounds where companies are in severe financial crisis, smaller in size (in terms of staff size, network reach) and have experienced a board-initiated leadership change -- a typical case history of SriLankan.

Unlike the companies that react to threatening decline and possible bankruptcy ‘sharp benders’ are companies that experience relative decline within their industry, are in need of renewal or improvement and subsequently successfully manage a process of sharp and sustained recovery.

Thus, our focus is on companies which, despite the severe nature of their decline, are very much concerned with implementing a suitable strategic reorientation in the course of their sharp bending recovery.

These airline companies registered extra high margin routes, such as to and from strategic capitals, saw daily frequencies increase threefold. They also deployed cost structure reconfiguration as part of their reorientation. Staff cuts were made where necessary and ancillary businesses spun off (SriLankan planning to divest catering and ground handling as SBUs augurs well) for a speedier turnaround.

High margin routes and competitive pricing is possible when one considers the growth scenario shown in Table 1.

China’s growth alone between 2014 and 2019 is estimated to be 230 million passengers. While Vietnam outbound travel is to increase annually by 7-8 percent. China will overtake the USA by 2019 and India will displace the UK by 2026.

Possibly SriLankan needs to review its traffic rights/freedoms (particularly the Fifth freedom (see Graphic 1) rights) to new destinations travelled by the emerging passenger profile from Vietnam and China. This would provide the airline mostly ‘green field options’, though competition will prevail with ‘SQ and Thai’ mainly, as domestic carriers in these markets are weak.

Furthermore, in most cases, new leadership was introduced to radically rework the business model and, most importantly, to oversee the unlearning of poor practices and establish a new corporate culture committed to delivering the revised business model.

(The writer is a Senior Consultant with HR Cornucopia and an institutional specialist with extensive experience on several World Bank/ADB and JICA development projects. He can be reached at [email protected])

Case study of turnaround of Turkish Airline

Flag carrier Turkish Airlines has generated a net pre-tax profit of US $ 153 million for 1Q 2015, compared with the US $ 110 million loss it posted for the same period last year.

This was possible due mostly to hedging in fuel prices (see Diagram 1) and several financial risk-mitigating measures which improved its competitiveness in a predominant European market, where growth according to IATA is forecasted only at 3.0 percent for the coming years.

Some of the ‘elements of risk’ viewed as fundamental to the health of its future cash flows and liquidity were:

The possibility of the company being prevented from achieving its business objectives by changes taking place in its short-, medium- and long-term cash position and in its portfolio investments.
The financial impact of changes in aviation fuel and carbon emission certificate prices.
The financial impact of changes in the market value of aircraft financing, which is through FX-denominated debt and on cash owing to interest rates movements.
The potential for losses in the event that a domestic or foreign financial institution or its counterparts, default on deposit, derivative or other transactions.
The airline also is able to free up capital for its sales promotion deploying world-renowned sports personalities in its image building (basketball legend Kobe Bryant and Soccer Great).

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The arduous task of turning the national carrier around

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