DALLAS – The catastrophe of 2020 saw global airline revenues fall to 2000 levels, leading to a record loss of US$168bn. Across the aviation ecosystem, only freight forwarders and cargo carriers made a profit.
Even before the pandemic, though, most airlines lost money. In fact, the airline industry has failed to earn its cost of capital every year of its existence.
But in the years preceding the pandemic, something began to change. Despite the industry’s overall weak performance, a small group of airlines did well. The chart below plots the economic performance of 122 airlines from 2012-2019.
It shows that over that period, more than three-quarters (77%) destroyed value. But 28 generated an average of US$8bn a year in economic profit.
The successful airlines came from a variety of regions and in a range of sizes and business models. What do they have in common?
We believe that airlines that create value do six things differently.
Best Airline Practices
They manage their capital base, especially aircraft. Return on invested capital is the best metric for measuring value creation. While most companies focus on improving the numerator (profits), some of the most successful ones generate value by carefully managing the denominator (invested capital). For airlines, this means aircraft.
There is value in having a good mix of new, efficient aircraft for high-utilization flying, and older, depreciated aircraft. The latter may have higher operating costs, but lower ownership ones and they do not need to be flown as intensively. One successful low-cost airline, for example, flies its newer, more efficient fleet for an average of 12 hours a day. It uses its older fleet when there is sufficient demand at the right yields.
They are careful about adding capacity. Counterintuitive but true: in our analysis, airlines based in slow-growing home markets performed substantially better than those in high-growth markets. Why? Because high-growth markets attract competition, forcing prices down, and encouraging airlines to add new aircraft to meet expected demand, putting pressure on their balance sheets.
This dynamic helps to explain why the fast-growing Asian region was the largest pre-pandemic value destroyer, while the mature and consolidated North American market did much better. But geography is not destiny; Latin America also consolidated but failed to return the cost of capital. The difference was that the successful North American carriers added capacity carefully.
They did so in markets where they had a competitive advantage and significant market share and at a rate less than that of GDP growth. The lesson: even airlines in fast-growing markets can improve returns by managing how they add capacity.
They offer ancillary options that their customers value. Revenues from ancillary services, such as baggage options, seat selection, upgrades, and priority boarding, as well as partnerships with other entities such as rental cars or travel insurance, can make a difference. Before the pandemic, airlines generated around US$110bn in revenues from the sales of ancillary products, or about US$67bn more than the industry’s absolute operating profits.
In short, without ancillary revenues, even successful airlines might have failed to return their cost of capital. And some airlines do much better than others at this. There is a positive relationship between ancillary sales performance and ROIC. Carriers whose passengers each spend at least US$20 on ancillaries generate 8.2% ROIC on average, which is more than five percentage points higher than airlines whose passengers spend less than US$5.
They create pockets of privilege in their flight network. Successful airlines create privileged niches—meaning unique origins-and-destinations (O&Ds)—in their flight network, often by using a well-designed connecting hub. Consider Panama’s Copa Airlines: about 45% of its passengers travel on privileged O&Ds—three times the industry average.
That is a large part of the reason that Copa is a consistent value creator. As airlines bring back flights, an effective strategy may be to design their networks with more privileged itineraries, for example by serving smaller cities and connecting the flights through large-scale hubs.
They differentiate themselves by their reputation. There is more information available to passengers than ever, and they use it. With a few clicks, they can readily get details on in-flight services, on-time performance, seat maps, review scores, and even environmental impact. Thus, it’s become more important for airlines to build a positive reputation. Carriers with good on-time and operational performance enjoy higher returns.
They are great organizations. Organizational health is a company’s ability to align around and achieve strategic goals; the link between organizational health and financial performance is strong and enduring. Not surprisingly, then, on average airlines were below-average performers on the Organizational Health Index (OHI).
Also not surprisingly, those with better organizational health tended to have better ROIC. Value-creating airlines have a strong strategic vision and clearly communicate it to all levels of the organization. They have well-understood values. They look outward and engage constructively with partners, communities, and governments.
No question: airlines have distinctive vulnerabilities. Pricing is cutthroat. Debt burdens are high. Pressure to become more environmentally sustainable is growing. Moreover, they are subject to external shocks that are beyond their control, such as the pandemic. For consistent success, then, they need to be both resilient and flexible—qualities embedded in the six practices described.
Imitation is more than the highest form of flattery: it can be a business strategy that gets airlines flying higher.
Article written by Alex Dichter and Steve Saxon. Alex Dichter is a senior partner in McKinsey & Company’s Boston office. Steve Saxon is a partner in Shenzhen.
Featured image: Salt Lake City E-Jets tails | United Airlines and Delta Air Lines. Photo: Michael Rodeback/Airways