Group Assignment Financial Analysis (BMS 320) Problem One:

The European Airline Industry

Group Members: Anas Zuhair Yousif, ID no.: 1050605017 Twana Taheseen, ID no.: 10506055141 Sarhang Ahmad, ID no.: 1050605217 Ahmed Nawzad, ID no.: 1050605242 Dastan M. Tahseen, ID no.: 1050605043 Shwana Muhamed, ID no.: 1050605137 Group and Class: Group C, Undergraduate 3 Course: Financial Analysis (BMS 320) Lecturer: Joseph Bamideli Date of submission: December 21st, 2011

Problem One Questions:

1- Evaluate how the rivalry among existing firms has developed after 2004.

A\ In most industries, the nature of rivalry among existing firms primarily influences the average level of the overall profitability. In the European airline industry, since early 2000s, the nature of rivalry showed consistent growth. This has been characterized by developing intense competition among existing firms, which pushed prices close to the marginal cost and forced an increase in the number of seats sold to cover operating expenses of the competing firms. Despite the moderate growth in sales, the industry particularly after 2004 has eventually been characterized by low profitability and poor performance of the overall airline companies. Thus, as the competition was intense, the profitability in the European Airline Industry was low, but started gradually increasing after 2004 with a moderate growth in the industry for a number of reasons:

The rivalry exhibited a moderate industry growth after 2004. In fact, between 2004 and 2007, the average Revenue per kilometer growth was a moderate 5 (from 80-84.05 in 2007), which could (more than sufficiently) cover the moderate 3 increase in Cost per kilometer (from 54.2-56.9 in 2007). Thus, calculating the profit margin per kilometer shows only 25.8 in 2004, while it reached 27.6 in 2007. On the contrary, until 2003 the Revenue per kilometer has been just 79.1; and the Cost per kilometer has been only 54 in the industry. With rivalry concentration, the industry became increasingly fragmented. After the liberalization period from 1987 to1997 in the airline industry, several new airlines entered the industry, while most of the national flag carriers such as Alitalia, British Airways, Lufthansa, KLM became inefficient and loss-makers, which didnt leave the industry as they were kept form bankruptcy by state subsidies and loans; others like Sabena and Swissair went bankrupt (Business Analysis, p.50). Accordingly, the market share of the Association of European Airlines (AEA) of the four largest AEA airlines gradually diminished from 58.5 percent in 2004 to 56.5 percent in 2007; likewise the market share of eight largest AEA airlines diminished from 79.4 percent in 2004 to 77.1 percent in 2007. On the other hand, Millions weekly seats of low-cost carriers (non-AEA members) has jumped from 1.9 million in 2004 to 3.9 million in 2007. This portrays how the market and industry became increasingly fragmented among competitors, as the market share of largest AEA airlines started gradually diminishing after 2004, against 2 million increases in the weekly seats of lowcost carriers (non-AEA members) that are probably new emerging potential competitors in the market.

With rivalry differentiation and switching costs, primarily there are still few opportunities for differentiation and low switching costs. In general, services delivered by the European airlines for short-distance flights within Europe were practically similar, excepting possibly the frequent flyer programs(like family seats flight, or students seats, economic class or business class flights), few opportunities were found to differentiate products in airline industry (Business Analysis, p.50). Thus, switching costs were also low because in some areas airports were geographically close and code-sharing agreements increased the number of alternatives that passengers could consider. Finally, with excess capacity, the European industry had a structural high excess capacity problem, while it continues increase with moderate percentages after 2004. Between 2002 and 2003, the average annual passenger load factor (measuring the percentage of passenger seats filled) was 73.3 percent. It further continued its increase by 2.4 percent, from 74.6 in 2004 to 77 percent in 2007. Hence, despite the consistent increase the passenger load factor, the cargo load factor has been constantly diminishing after 2004. Between 2004 and 2007, the cargo load factor (cargo carrying capacity percentage) recorded a steady decrease by 2.5 percent, from 36.8 percent in 2004 to 34.3 in 2007. After all, the overall load factor increased by 1.3 percent, from 68.4 percent in 2004 to 69.7 percent in 2007. Thus, 1.3 percent is a moderate increase over three years, yet as airlines lacked adequate opportunities to differentiate, they obviously continue engaging in price competition to fill up their empty seats or overall excess capacity; that is particularly as there are significant exit barriers for several firms in the industry especially the state owned firms.

As a result, with the intense rivalry and low barriers to entry in European airlines industry the price competition was severe among the existing airlines. Further, the national flag carriers airlines generally failed reallocate and restructure the capacity due to the government intervention in the industry. Such factors clearly led to the state of low profitability in the industry. However, the potential for profit making is entitled to increase after 2004 for internal restructuring in the European airline industry. Indeed, after 2004, it is estimated that most of European airlines started cutting capacity like cargo load factor. Between 2004 and 2007, the cargo load factor recorded a steady decrease by 2.5 percent, from 36.8 percent in 2004 to 34.3 in 2007. This led to an overall improvement in passenger load factor, which increased by 2.4 percent, from 74.6 in 2004 to 77 percent in 2007. Thus, the average Revenue per kilometer growth was a moderate 5 (from 80-84.05 in 2007), which could (more than sufficiently) cover the moderate 3 increase in Cost per kilometer (from 54.2-56.9 in 2007). Therefore, signs of industry enforcement by applying mergers among different airlines, along with opening up new

markets for European airlines after EUs open skies agreement with the US government(Business Analysis, p.52). As a result, despite the intense rivalry among existing firms, the profitability in the European airlines should have improved after 2004 with achieving moderate industry growth.

Evaluate the influence of rising fuel prices on the AEA airlines profitability between 2003 and 2006. If fuel prices had not increased after 2003, what would have been the pre-interest breakeven load factor in 2006 (assuming all other factors constant)?
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A\ The Association of European Airlines (AEA) has been immensely influenced by the rising fuel prices, particularly its revenue and consequently AEA airlines profitability potential between 2003 and 2006. In fact, the fuel costs to total costs had been steadily rising from 12.1 percent in 2003 to 22.8 percent in 2006; that means fuel costs have increased by 10.7 percent between 2003 and 2006. While on the same period and time, the annual revenue per kilometer has been indicating growth too by moderate 5.4 increase (from 79.1 in 2003 to 84.5 in 2006), which could (more than sufficiently) cover a minor 3 increase in cost per kilometer (from 54 in 2003 to 56.9 in 2006). To explain, primarily rising fuel prices and accordingly rising fuel costs to total costs have a direct effect on raising the total cost of services and the cost per kilometer as shown earlier in numbers, which typically reduces profit potential of AEA airlines. However, in the course of considerable rise in fuel prices, a minor 3 increase in the cost per kilometer happens, along with a moderate 5.4 growth in the annual revenue per kilometer between 2003 and 2006. That minor increase in the cost per kilometer against high fuel prices is justified by AEA airlines eventual attempts to cut operating costs of sales and administration that apply the business. Moreover, the consistent increase in revenue per kilometer, since 2003, indicates a steady increase in profit margin per kilometer calculated as 25.1 in 2003 per kilometer, it reaches 27.6 in 2005 and ends by 27.6 in 2006. This shows that high prices are being charged by AEA airlines for their services and costs per kilometers are being cut to make up for the rising fuel costs to total costs between 2003 and 2006. Thus in that sense, the average AEA operating margins before and after paying interest rates has recorded significant increases in the industry. Despite the fact that fuel prices have been increasing considerably since 2003, the average AEA operating margins (before and after paying interest) became positive, then on average in 2004, and gradually improved thereafter. Indeed, the average AEA operating margins (or what remains from revenue after paying all variable costs) before paying interest rates was about 0.3 percent and after interest was 2.1 percent in 2003; it became on average 2 percent before interest, and 0.5 percent after interest in 2004; later it gradually improved to reach 3.4 before interest, and 2.5 percent after interest in 2006. In the light of steady increase in operating margins, it shows that AEA airlines are changing

their pricing strategy toward gradually increasing their profit margins on their unit sales in order to pay for their variable costs of services, especially for the rising fuel costs, and others like wages, advertising bills, materials, etc. Thus, the new pricing strategy aims at consolidating the operating efficiency of AEA airlines by keeping it safe from any sudden crisis such as fuel shortage crisis, and makes it sustainable over the near future. As a result, the rising fuel prices between 2003 and 2006 typically increases costs of services, decreases airlines total revenues, and decreases profit potential and profitability. However, by the policy of cutting the operating costs and consistently increasing average AEA operating margins as shown between 2003 and 2006 (before and after interest) to increase the total revenue and satisfy the variable costs, the profit potential increases and the AEA airlines profitability even with the rising fuel prices is relatively entitled to improve between 2003 and 2006. On the other hand, if fuel prices had not increased after 2003, the pre-interest breakeven load factor in 2006 would have been the same figure or amount in 2003. To explain, the pre-interest breakeven load factor is the payload of number of passengers or cargo necessary for an airline to breakeven preceding the payment of interest (investor words,dd). Thus, the fuel cost to total cost of AEA airlines in 2003 have been 12.1 percent, while it gradually increased thereafter to reach 22.8 percent in 2006. The preinterest breakeven load factor, concurrently, in 2003 have been 68.3 percent, while it diminished gradually to reach 67.3 percent only in 2006. That is, the influence of the rising fuel prices on the AEA airlines after 2003 have been negative on the pre-interest breakeven load factor due to the increase in AEA airlines operating costs and unit sales prices. That means, because of rising fuel prices after 2003, the operating costs (mentioned earlier) have increased and resulted in primary decrease in revenue, increasing the seat booking prices, then almost decreasing the percentage of seats filled and necessary load of number of passengers and cargo for the AEA airlines to breakeven, preceding the payment of interest. Therefore, if fuel prices had not increased after 2003, the pre-interest breakeven load factor after 2006 would have been figure or amount in 2003, which is 68.3 percent.

During the period examined, some airlines started to charge fuel surcharges to their customers. For example, late 2007 KLM charged its customers 27 on European flights and 80 on international flights. Other airlines had similar surcharges. How do such practices affect your answer to question 2?
3-

A\ It is generally given that fuel costs to total costs had been steadily rising from 12.1 percent in 2003 to 22.8 percent in 2006; that means fuel costs have increased by 10.7 percent between 2003 and 2006. Based on that fact that fuel prices are recording a high percentage of increase during the period examined, charging similar fuel surcharges by AEA airlines to their customers it is a given strategy to ensure growth and given procedure to keep a steady level of profit margins and stabilize profitability of the European airlines. To begin with, as KLM similar to other airlines in late 2007 charged its customers 27 on European flights, and 80 on international flights, the charge for international flights seemed a far-out higher or of higher price than the European flights. That overall poses questions about the price elasticity of demand and the action plans used to actualize a steady level of profit margins and stable profitability. In fact, along with the increase of fuel prices or fuel cost to total cost, the Revenue Passenger Kilometers (RPK), Cargo Tonne Kilometers (CTK), and Available Seat Kilometers (ASK) have been steadily increasing in millions between 2004 and 2007 whereas their growth rate percentages were either fluctuating or decreasing. To examine these figures, Revenue Passenger Kilometers (RPK) in 2004 was around 656,677mn. and in 2007 it reached 781,160mn. while the RPK growth has turned from 9.7 percent in 2004 to 5.3 percent in 2007 ; Cargo Tonne Kilometers (CTK) in 2004 has been 36,009mn. and it increased to 38,635mn. in 2007 while the CTK growth has been fluctuating and turned from 10.6 percent in 2004 to 3.3 percent in 2007. Furthermore, Available Seat Kilometers (ASK) that shows the inbuilt capacity of AEA airlines, in 2004 has been 880.085mn. and it reached to 1,015,004mn. in 2007, while the ATK growth has been fluctuating too until it turned from about 8 percent in 2004 to 4.6 percent in 2007. These figures show the reality that the steady increase in Revenue Passenger Kilometers (RPK), Cargo Tonne Kilometers (CTK), and Available Seat Kilometers (ASK) has been due to the price inelasticity of demand to the AEA airlines, while the fluctuation and decrease in (RPK), (CTK), (ASK) growth rates is due to the limited growth in unit sales and services of AEA airlines after charging fuel surcharges. Therefore, the price inelasticity of demand (the unchanging demand to increase in price

in this case) to the AEA airlines even with charging fuel surcharges can not be actualized but with specific action plans. One of these action plans is price discrimination, which is selling the same service at different prices to different customers depending customers special needs and orders and/or their geographical locations (Business Dictionary.com). Accordingly, customers special needs and orders can be actualized through segmentation of services; that is like providing business or economic class seats or flights, providing family seats or special family flights, and providing students seats with special discounted prices, etc. Thus, 80 for international flights charge seems realistic based on the steadiness of demand to price changes all along with segmentation of services that actualize this situation. As a result, the AEA airlines can efficiently charge their similar fuel surcharges that should keep a steady level for profit margins on sales and consequently keeps a stable level of profitability if the AEA airlines are on or above the minimum efficient scale of production; that is the lowest point of production a company can reach to while taking full advantage of the economies of scale regarding supplies and costs (Investopedia ULC, 2011). Furthermore, the pre-interest breakeven load factor of the AEA airlines is entitled to be more stable along with the charge of fuel surcharges to the customers. The operating margins of the AEA airlines became positive, on average in 2004 and gradually improved their after. What do you think are the most important drivers of behind this development? (Also consider your answers to question 2 and 3).
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A\ The operating margins of the AEA airlines has been developing consistently between 2003 and 2007 driven considerably by the rising fuel prices on the AEA airlines, and then by the increasing the load factor or capacity of services of the AEA airlines in the European airlines industry. Indeed, as mentioned earlier, the average AEA operating margins (before and after paying interest) became positive, then on average in 2004, and gradually improved thereafter. Indeed, the average AEA operating margins (or what remains from revenue after paying all variable expenses) before paying interest rates was about 0.3 percent and after interest was 2.1 percent in 2003; it became on average 2 percent before interest, and 0.5 percent after interest in 2004; in 2006 later it gradually improved to reach 3.4 percent before interest, and 2.5 percent after interest. These sets of annual increases comes after that fuel costs to total costs had been steadily rising from 12.1 percent in 2003 to 22.8 percent in 2006; that means fuel costs have increased by 10.7 percent between 2003 and 2006. Thus, as a result of the increasing fuel prices, the AEA airlines are compelled to raise their average AEA operating margins to keep their revenues at a level that satisfies their operating expenses and variable costs. On the other hand, a structural excess capacity problem in the AEA airlines or with the increasing load factor is another most important driver behind the operating margins development. Thus, the European airlines seem to almost have engaged in price competition rather than differentiation to fill up their empty seats.

In fact, average annual passenger load factor (measuring the percentage of passenger seats filled) was 73.3 percent in 2003. It further continued its increase by 2.4 percent (from 74.6 in 2004 to 77 percent in 2007). Hence, despite the consistent increase the passenger load factor, the cargo load factor has been constantly diminishing after 2004. Between 2004 and 2007, the cargo load factor (cargo carrying capacity percentage) recorded a steady decrease by 2.5 percent (from 36.8 percent in 2004 to 34.3 in 2007). After all, the overall load factor increased by 1.3 percent, from 68.4 percent in 2004 to 69.7 percent in 2007. It seems that the cargo load factor is to be cut AEA airlines for increasing load factors of passengers since cargo loading is usually an area of narrow specialization of an airline rather than passenger load factor that is unseal. But in any case, the consistent increase in load factor of carrying passengers or even in the overall capacity is another most important driver toward gradual increase in the annual average of overall AEA operating margins until it becomes positive and improves both before and after paying interests. while even as long as the it was clear that the demand is stable even with price changes, then AEA airlines could be more able to raise their average operating or profit margins (whenever possible and required) in order to cover their increasing operating expenses and variable costs especially the rising fuel prices. As a result, the gradually developing operating margins and overall improving, makes an a stable level of profitability if the AEA airlines are on or above the minimum efficient scale of production; that is the lowest point of production a company can reach to while taking full advantage of the economies of scale regarding supplies and costs (Investopedia ULC, 2011). Furthermore, the pre-interest breakeven load factor of the AEA airlines is entitled to be more stable along with the charge of fuel surcharges to the customers. pp notes continue
include overall load factor Revenue_ cost= profit use it and ask?

It is generally given that

Moreover, the consistent increase in revenue per kilometer, since 2003, indicates a steady increase in profit margin per kilometer calculated as 25.1 in 2003 per kilometer, it reaches 27.6 in 2005 and ends by 27.6 in 2006. This shows that high prices are being charged by AEA airlines for their services and costs per kilometers are being cut to make up for the rising fuel costs to total costs between 2003 and 2006. Thus in that sense, the average AEA operating margins before and after paying interest rates has recorded significant increases in the industry. Despite the fact that fuel prices have been increasing considerably since 2003, the average AEA operating margins (before and after paying interest) became positive, then on average in 2004, and gradually improved thereafter. Indeed, the average AEA operating margins (or what remains from revenue after paying all variable costs) before paying interest rates was about 0.3 percent and after interest was 2.1 percent in 2003; it became on average 2 percent before interest, and 0.5 percent after interest in 2004; later it gradually improved to reach 3.4 before interest, and 2.5 percent after interest in 2006. In the light of steady increase in operating margins, it shows that AEA airlines are changing their pricing strategy toward gradually increasing their profit margins on their unit sales in order to pay for their variable costs of services, especially for the rising fuel costs, and others like wages, advertising bills, materials, etc. Thus, the new pricing strategy aims at consolidating the operating efficiency of AEA airlines by keeping it safe from any sudden crisis such as fuel shortage crisis, and makes it sustainable over the near future.

Bibliography Palepu, K.G. and Healy P.M. and Peek, E. (2010). Business Analysis and Valuations IFRS edition. Second edition. South Western, Cengage Learning EMEA
http://www.bts.gov/publications/special_reports_and_issue_briefs/issue_briefs/ number_08/pdf/entire.pdf

Minimum efficient scale Definition of 'Minimum Efficient

Scale'

http://www.investopedia.com/terms/m/minimum_efficiency_scale.asp#axzz1 h1Abm9D9 investopedia UCL 2010