AMandL

The changing context: June 2011

The early season sun in Northern Europe has evolved into a more traditional temperate, cool and wet summer.

In Mediterranean Europe the enjoyment of the sunshine has been tempered by the economic problems faced by Greece, Italy, Portugal and Spain. The most serious problems have been in Greece and Portugal where bail out funds have had to be provided by the EU, IMF and European Bank. In return a series of austerity measures have been demanded and these are impacting upon the ability of people to travel by air in addition to other reductions in expenditure.

Fuel prices present a continuing problem for European airlines. The current price has dipped to just above $100 a barrel. This is still significantly above the $80 a barrel expectation that most airlines were using for their planning in 2010. All airline sectors are affected and British Airways, easyJet and Thomas Cook have all reported on the adverse effect of the higher prices on their profitability. Most claim that they can only reclaim about 50% of the increased costs through fuel surcharges. Charging more they claim has a significant effect on demand.

On the international stage Europe in the form of the EC is attracting growing criticism, and legal challenges, over the implementation of the Emissions Trading Scheme due to start in January 2012.

Within this context a number of interesting developments are taking place.

Aer Lingus and TAP

Both these small but significant airlines are effectively for sale. TAP explicitly so as a result of the terms accepted by Portugal as a condition of their financial bail out. Aer Lingus implicitly as the Irish government ponders whether it too should sell its remaining stake in the national carrier.

TAP presents a very interesting opportunity. From near bankruptcy in 2008 it has returned to profitability and was preparing for privatization before the pressure to realize state assets as part of the reconstruction of the Portuguese economy.

With its very strong routes to Angola, Brazil, and Mozambique TAP is likely to be of interest to several other airlines. IAG will probably see it as adding to its European-South American strength as it merges British Airways and Iberia. Lufthansa may also see it as an opportunity to strengthen its South Atlantic presence and compete with IAG more effectively in this segment. Air France may be less interested as it already has strong route network connections to Brazil and Central Africa. There is also speculation that a newly merged TAM and LAN (LATAM) could be interested, but the likely cost of growing the TAP long-haul fleet and the immediate challenge of gaining regulatory approval, and then merging, may prove a challenge too far at the moment.

The Portuguese government has been strengthening links with Qatar, but whether this or another Gulf State would wish to invest in a European airline is uncertain.

Wild cards could be private equity or a Russian backed interest.

Aer Lingus may present a different opportunity. There are no indications that the Irish government does wish to sell its stake. Indeed it has retained this to date primarily to ensure some state control over the national carrier and to protect the economically important tourist and business interests served by Aer Lingus. The stake was also useful in blocking the two Ryanair attempts to merge with Aer Lingus. Now, however, looking at the precedent set by the EC in blocking a proposed merger between Aegean Airways and Olympic Air they may rethink whether they need to retain such a large stake. The EC ruling on the Greek airlines was on the basis that moving to a single carrier would reduce competition. This decision was taken despite the Greek plea that a merger is essential otherwise both airlines might fail. Such a decision suggests that the EC would be unlikely to agree a merger between Ryanair and Aer Lingus. So just maybe the stakes of both the Irish government and Ryanair might be available at the right price.

New business models

Elsewhere in Europe some intriguing new business models are being piloted.

Air France, long centered on its Parisian hubs, is establishing four regional bases in Bordeaux, Marseilles, Nice and Toulouse. Each of these will have up to 10 aircraft and locally engaged crews. The plan is to reduce costs through the operating efficiencies this will deliver, but not to offer a low cost product as such. All services will be branded as Air France and deliver the expected product and service delivery. By reducing the cost the airline intends to compete on quality against the true low cost airlines that will still have a cost, and therefore price, advantage.

The first base to be established will be Marseilles.

UK regional Flybe is entering into two new relationships. It is deepening its association with British Airways and is investing in a joint venture with Finnair.

A new code share agreement with British Airways will see Flybe feed British Airways Gatwick services from Newcastle and the Northeast of England: a region that has been under served by British Airways since the days of Northeast Airlines and then the UK and Ireland division.

The joint venture with Finnair is the acquisition of Finnish Commuter Airlines and to re-establish this as Flybe Nordic: an airline to be operated and managed by Flybe, and which will provide direct regional connections across Scandinavia.

easyJet and Ryanair

Never short of providing a good headline both easyJet and Ryanair have been in the news recently.

Sir Stelios Haji-Ionnou has mounted another very public attack on the Board of the airline he founded, and of which he is still a significant shareholder. In his latest attack he complains that the Board did not consult shareholders before confirming an order for additional Airbus aircraft and that in switching part of the order from Airbus A319 to Airbus A320 aircraft there is also a significant increase in the capital expenditure required. EasyJet reject this claim, arguing that the Board has acted strictly in accordance with an agreed mandate.

The new Chief Executive, Carolyn McCall, meanwhile has been carefully repositioning easyJet as the European airline of choice, rather than just as a low cost airline. Development of seat allocation and the ability to change flights are instances of the evolving product aimed at better meeting business and leisure traveler needs. easyJet is investing in a new base at Southend where there is diagnosed to be an unmet business and leisure travel demand. The proposition is of appropriate value rather then net cost.

Ryanair has announced that it is slowing its rate of growth and is quite prepared to ground up to 80 mainly new aircraft this winter if demand does not permit them to be flown at a profit. The flexibility of the Ryanair approach continues, however, with plans to invest in a new base at Manchester, continuing the evolution of the airline into operating from major as well as secondary airports.

Emissions trading scheme

The EC determination to implement the scheme continues to attract international criticism. The US airlines under the auspices of the TAA have made an oral submission to the European Court of Justice arguing that the EU has no jurisdiction beyond European skies. This view would appear to be echoed by outgoing IATA Director General Giovanni Bisignani who argues that the jurisdiction for aviation emissions lies with ICAO.

It appears that the EU is unlikely to be moved by these submissions; unless a European Court ruling goes against their jurisdiction. It is therefore possible that there may be some form of reciprocal sanctions adopted by other governments or airlines from January. This could complicate matters for European airlines at a time when they are desperately looking for stability in a harsh economic climate.

Slot allocation regulations

The EC is proceeding with consultation on a proposed revision of the European regulation on slot allocation.

Amongst measures proposed is the introduction of market-based mechanisms to ensure that slots are used efficiently and a reduction in the number of slots automatically reserved for new entrants. In essence the proposals seem to be an attempt to regularize procedures in line with current practices in some parts of the EC; removing the grey trading that is now commonplace. The driver is also to increase the efficiency of the overall air traffic management system and by making slots tradable to deter airlines from holding on to slots that deliver little value to their networks.

The biggest losers if such changes are introduced are likely to be smaller and regional airlines that may well be priced out of the major airports whose slot values will be determined by the value of the international flights that they can be used for. This may also hinder the development of businesses in some of the more dispersed regions of Europe.

The EC is reported to be concerned about the latter situation, and may include some public benefit safeguards in any revised regulation. More generally, however, the EC policy is to try and move more air traffic from air to rail services and they see a revised regulation as supporting this policy.

Rail travel is increasing. The EC has noted the rapid reduction in fares on Beijing to Shanghai services consequent upon the opening of the new high speed rail link between the two cities. This mirrors the European experience when high speed rail first linked London and Paris, Barcelona and Madrid, and Lyons and Paris. The interest of Deutsche Bahn in operating services through the Channel Tunnel, linking London, Amsterdam, and Cologne is the sort of investment that the EC wishes to encourage.