Is a clear link between airline ROIC and the passenger experience emerging?

December 4, 2012

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iStock money main 150x150 Is a clear link between airline ROIC and the passenger experience emerging?Return on invested capital (ROIC) is a universal concept firmly entrenched in Finance 101 textbooks and one of the fundamental metrics used to measure the performance of a given company. But until the last couple of years, ROIC has been virtually absent from the financial discussions among airline US executives as they focussed on more fundamental aspects of the business such as pairing down debt and building crucial cash reserves. Now with their increasing financial prowess, airline chiefs are rapidly beginning to tout ROIC targets and in some cases meet those returns on a consistent basis. Increasingly, a healthy amount of airline investments are aimed at improving the passenger experience – albeit at a price to the customer through add-ons that carriers have determined travellers are willing to pay for.

Despite lingering macro economic uncertainty driven by weakness in Europe, the now-familiar highly volatile fuel price environment and the threat of more government intervention in airline operations in some regions, IATA estimates a global profit of USD4.1 billion for the airline industry in 2012 and net earnings of USD7.5 billion for 2013. While those profits translate into razor thin pre-tax earnings margins of 1.6 per cent and 2.6 per cent respectively, it is vast improvement from the USD4.6 billion global airlines bled in 2009.

With three years of profitability under their belts, airlines can now get more serious about other fundamentals of their business beyond simply holding their heads above water. “We have entertained…this crazy metric called ROIC, which is probably a metric that we haven’t heard in the airline business for a long, long time,” JetBlue CFO Mark Powers recently declared to investors. “And we have absolutely embraced this return metric.”  JetBlue has pledged a 1 per cent improvement annually in its ROIC; it recorded a return on invested capital of 4 per cent for the 12 months ending 31 December 2011.

MOVING ON UP

The largest airline during 2011 in terms of passengers carried Delta has seen its profitability swing from a nearly USD9 billion loss in 2008 during the height of the oil price crisis to a 2011 profit of USD854 million in 2011, and with the its improved fortunes it has declared a ROIC target of 10-12 per cent on an annual basis. Emphasising Delta’s profitability in 2010, 2011 and its USD1 billion profit through the first nine months of 2012, company CEO Richard Anderson believes Delta’s stated ROIC goal is “a solid number for us going forward. And this is a management team that is incredibly serious and intent on hitting numbers for our shareowners”.

Seattle-based Alaska Airlines has been a pioneer in elevating the role of ROIC in financial discussions during the last few years, earning bragging rights as one of the top performers in delivering on its stated goals of maximising its capital investments. “It appears very likely that we’ll exceed our 10 per cent after-tax ROIC target again this year [for 2012],” CFO Brad Tilden declared to investors during mid-2012. “This would be the third year in a row we’ve been able to do so. Our growing track record gives me confidence that we’re making the right changes to our business that will enable us to reach our goal of an average 10 per cent ROIC across the peaks and valleys of our business cycle.” Tilden stressed that as recently as 2009, Alaska’s ROIC was just a mere 6 per cent.

“I think the fact that ROIC is a very important aspect of today’s vernacular is one of the most promising changes in the [airline] business,” remarks William Swelbar, research engineer for MIT’s Centre for Air Transportation. He believes the rising prominence of ROIC in financial discussions is a result of tightening credit markets that previously made capital available to airlines “with little justification”.

PASSENGER INVESTMENTS TAKE PRECEDENCE

For Alaska, Delta, JetBlue and United Airlines – which recently declared a long-term ROIC goal of 10 per cent – the new emphasis on attaining returns that exceed the cost of capital has been accompanied by substantial investments in improving the customer experience both on board and within the airport environment.

All of these carriers are focusing their spend on several aspects of improving the passenger experience ranging from offering inflight connectivity, expedited security screening, self bag-tagging, expansion of power outlets and USB ports at airports and massive interior retrofit programmes covering the installation of full-flat beds in order to attract and retain high-yielding business passengers.

Over the last couple of years Delta has undertaken a massive USD3 billion product enhancement scheme that encompasses offering Wi-Fi on all of its jets, recharging stations at airports, full-flat seats, a new ‘Economy Comfort’ expanded legroom offering, updated ‘Sky Clubs’ for its frequent flyers and terminal upgrades in Atlanta and New York. “We’ve put a lot of investment into the product and it’s paid tremendous dividends with our revenue performance,” says company CFO Paul Jacobsen. Delta’s top-line revenues for the nine months ending 30 September 2012 jumped 5 per cent to USD28 billion.

JetBlue has expanded its ‘Even More’ legroom offering to its smaller-gauge 100-seat Embraer E-190s after debuting the product on its Airbus A320 fleet in 2008. The carrier estimates revenue from its Even More product, which includes expedited security at select airports, should jump 25 per cent year-over-year in 2012 to USD150 million, which will help drive its overall ancillary revenue growth to USD600 million in 2012, a 12 per cent rise year-over-year.

JetBlue CFO Powers is particularly bullish on maximising JetBlue’s ancillary revenue, much of which is driven by products that ease the travel experience or enhance passenger comfort. “I love it because of course typically the cost of generating a dollar of ancillary revenue is a lot cheaper than buying an airplane and fuelling it up,” he concludes.

CONNECTION OR COINCIDENCE?

One question arising as carriers declare definitive ROIC targets and focus a significant portion of their investments on improving the passenger experience is if a direct relationship exists between those two concepts. Swelbar of MIT believes “airlines increasingly care about passengers and what passengers want”. As carriers have gone through a process of stripping away services previously included in the overall cost of a ticket, airlines are introducing products and services passengers are willing to pay for. The question being mulled, he says, is if the investment in a given project meets an airline’s ROIC target, and if the calculations are favourable, the investment will get a green light from management.

Each carrier obviously has its own nuances in determining the direct returns of passenger investment, remarks Atmosphere Research Group co-founder and chief researcher Henry Harteveldt.

US Airways has clearly concluded that there are returns to be made from full-flat business class seats featured in the Envoy class of its Airbus A330s, but has publicly declared that it cannot earn returns by investing in dedicated inflight entertainment on its US domestic services, reasoning passengers are better off entertaining themselves with their own devices. Yet at the same time the carrier has calculated it will capture a return in offering Wi-Fi on 90 per cent of its domestic fleet.

While Delta has spent a generous amount for numerous upgrades to the passenger experience, Harteveldt also points out the carrier “is not afraid to buy used aircraft”, citing its deal to acquire Boeing 717s presently operated by Southwest subsidiary AirTran, and Delta’s operation of 49 McDonnell Douglas MD-90s with an approximate average age of 15 years. He remarks it is intriguing that Delta has opted not to install inflight entertainment on those sub-fleet types since the carrier cannot justify the investment on those particular jets given the aircraft’s weight and performance.

At times carriers can miscalculate their investments in the passenger experience, remarks Harteveldt. He cites a previous decision by American Airlines to install angled lie-flat seats in business class due to the extra real estate that a fully flat offering would require. “In this case American put financial returns ahead of the passenger experience,” says Harteveldt. “I think they goofed.” Now American is playing a game of catch-up with its competitors, consolidating business and first class on its 777-200s and offering full-flat seats in both business and first class in its new-delivery 777-300ERs, he concludes.

Overall, Harteveldt believes it is tough to discern a black-and-white connection between ROIC and a focus on passenger experience improvements. With respect to items such as aircraft investment and terminal upgrades “it is easy to adjust the dial on ROIC”, he remarks. Other carriers undertake certain investments more as marketing and public relations initiatives, Harteveldt concludes.

He questions if the shower offered in the first class cabin of Emirates’ Airbus A380s is a means to meet ROIC targets, or if it was designed to generate marketing buzz. Another product offering that could potentially blur the lines is the duty free boutique featured on Korean’s Air A380. Harteveldt reasons it is not entirely clear if ROIC played a role in the carrier’s decision create a live inflight shopping experience.

MUTUALLY EXCLUSIVE

Others take a completely contrarian view on the matter of whether or not the passenger experience plays a role in calculating return on invested capital.

Hamlin Transportation president George Hamlin believes it is a stretch to conclude that any relationship exists between passenger experience investment and the setting of ROIC targets by various airlines, or that carriers making investments in products that benefit travellers achieve higher returns. He cites ultra low-cost leisure carrier Allegiant Air’s impressive ROIC, which was 15.5 per cent for the 12 months ending 30 September 2012.

Allegiant’s onboard amenities are sparse, and earlier in 2012 the carrier began charging passengers for any second carry-on bag that does not fit below a seat. In so doing, it joined fellow ultra low-cost carrier Spirit Airlines, which introduced a similar charge in 2010 and recently hiked the price to USD100 for passengers opting to pay the fee at the boarding area.

Spirit and Allegiant base their business models on offering very low fares and then charging for various add-ons including carry-ons, checked baggage and even water.

Hamlin likens his determination that there is no relationship between ROIC calculations and the passenger experience to the statistical term ‘autocorrelation’, which entails two series of data rising that appear to correlate “but have nothing to do with each other”. Any real exploration between ROIC and the passenger experience must examine how passengers select their flights, he surmises, which still boils down to price, schedule and points or frequent flyer affiliation. While passengers willingly complain about poor service or product, “at the end of the day it is about a cheap seat”, he says. He believes an improved passenger experience could possibly be one of many elements in ROIC calculations, “but it doesn’t mean it is a real driver”.

But an improved experience for high-yielding business travellers is at least a well-established by-product of carriers establishing and zeroing in on ROIC targets. Harteveldt explains that full service carriers have learned that passengers travelling in the standard economy cabin are not willing to pay more than the average economy fare, so most of the investment is in premium classes. “They’re [airlines] are putting investment in what people will pay for,” he states.

It is still early days for return on invested capital to become a regular metric used by airlines to gauge their financial success, and as it gains traction in discourse, any distinctive links between ROIC and the passenger experience will emerge. But as the ROIC metric continues to gain momentum as an indicator of airline financial health, Swelbar of MIT believes that airlines are focussed on developing more differentiated products than during the last five-to-seven years. Knowing specific offerings from carriers such as Spirit, Delta or Southwest will certainly factor into a passenger’s calculations as they “sit at home and book their trips”, he says.

The changes carriers have made in their businesses to produce consistent returns have allowed them to turn their attention to product distinction, he reasons. “As the industry was forced to cut costs aggressively there was no brand differentiation. You’re now seeing us get into a period where the opposite is true.”

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About Lori Ranson

Lori Ranson has spent more than a decade covering the commercial aviation industry, specialising in the North American market. Previously she was Americas Air Transport Editor for Flightglobal and currently is a Senior Analyst at the Centre For Aviation and a freelance journalist. Her coverage has touched on all aspects of commercial aviation, including marketing and distribution, network development, safety, maintenance, repair and overhaul, aircraft programmes, alliances, regulatory developments and finance.

View all posts by Lori Ranson
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One Response to “Is a clear link between airline ROIC and the passenger experience emerging?”

  1. Frequent Traveller Says:

    LCCs too thrive on ancillary extras, orchestrating – fine-tuning – basic operations to just about breaking even based on their bottomlines, factually aiming to make their day collecting CIL/COL (Checked-In Luggage/Carry-On Luggage) revenues and similar other ‘extras’.

    Yet, more and more LCCs are gearing themselves up to attempting incursions at Product Differentiation, to cater for the more lucrative Premium segments of Feeder business, challenged however in the venture not to lose their souls to Legacy, staying a proper LCC ?

    The issue is about a hair-fine dilemma between enhanced leg-appeal (better service soft-ware) vs upgraded pax-appeal (better cabin hard-ware), yet retaining the basic Bottomline Strategy ?

    Specially prepared for the concerned Retail Psychologists, the nitty-gritty of RASM-CASM spreadsheets analysing LCC bottomline feeder operations unveils an interesting paradox : ( click here )

    Reply

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