Category: Airlines and Aviation

Airline Industry 103: Fares Part 1 of 2 – How Airlines determine them (and how to properly compare them)

Class is now in session for our third lesson.

This is not my area of specialisation so my knowledge in it isn’t as deep as in other aspects of the airline industry. That said, I’ve learned a fair amount from my more knowledgeable colleagues over the years and I thought I’d share the same with you. This will be covered in two parts – the first dealing with Factors affecting pricing and the second dealing with Revenue Management – Fare classes, restrictions, overbooking etc.

First, let’s start with the factors that determine ticket pricing. There are several of these – each with a varying level of importance depending on where you are. The main ones are as below:

  1. Route Product – Do you offer a direct flight or are there connections / stops to be made? The general preference for many travellers is to have a direct flight (as it always takes the shortest travel time) so airlines will charge a premium for it.  What airport are you landing in? For example, you may fly from Nairobi to London, but there are six international airports in the London Metropolitan area (Heathrow, Gatwick, Stansted, Luton, City and Southend) each with varying desirability. Heathrow is the busiest and has the most connections so a premium might be charged for flights into Heathrow as opposed to say, Stansted.
  2. Time of Day – This is another determinant of the ticket pricing but it’s less straightforward in how it affects the price. It often depends on the type of traveller being mainly targeted. Whereas Business Travellers tend to prefer night flights so they can maximise their daytime working hours, a VFR passenger – Visiting Friends and Relatives – might not be very fussed about whether they travel at night or during the day. Another aspect of Time of day is convenience of Departure or Arrival Time. E.g. a flight that lands at a final destination at 2am will likely be less desirable than one that gets there at 7am and the airline might have to price lower in the first case to entice passengers. SIDE NOTE: In some cases, the airline might have little choice in the time of day it flies into a particular airport. The busiest airports have strict restrictions on take off and landing slots and the airlines do not have the option to deviate. Heathrow is a perfect example.
  3. Day of Week – Like Time of Day, day of the week pricing is dependent on the traveller being targeted. E.g. on the Nairobi to Ukunda (South Coast) route, most of the travel is leisure. Tickets for travel to Ukunda on Tuesday will likely be cheaper than tickets on Friday due to the number of travellers going on a weekend getaway.
  4. Season – This one is more self explanatory, in certain seasons more travel is expected to certain destinations and so a premium is charged. For example travel to Mombasa or Kisumu from Nairobi on the 23rd/24th of December is going to be more expensive than travelling on the 26th/27th.
  5. Cost of Operations – Sometimes there are unique restrictions that make travel to one place more expensive than travel to another, even if they are a similar distance apart. An example might be fuel price or airport taxes – one place might have a significantly higher fuel prices or airport taxes than another and the airline will need to factor that into their pricing.  Another example might be the Alternate airport. On all flights the airline plans for a contingency where they might have to divert to an alternative airport – e.g. if there is an issue with the destination airport. The plane will carry sufficient fuel to get to their destination plus an amount to get them to their alternate. If the only available alternate is very far away, then the airline must carry even more fuel than it would on another route. More fuel is more weight, more weight costs more money. SIDE NOTE: On all pricing the Airline has to factor in its indirect operating costs, i.e. it’s overheads, costs of financing and the cost of ownership of the aircraft.
  6. Competition – This may be the biggest determinant of price and it comes with the most different ways of affecting price. Actually, in many ways it encompasses aspects of all of the other factors. Do I have competition on this route? Naturally a premium will be charged if there is no competition. If I have competition, how does their route product compare to mine? How does their timing compare to mine? On what day of the week do they travel? Do they only travel seasonally? (Like charter operators)

In reality all of these factors will apply in varying degrees on a route by route basis. The airline must come up with a pricing strategy that balances all of the different factors while still trying to remain profitable. On some routes – when there’s a strategic benefit – the airline may have to accept losses when they can’t overcome the factors that drive their prices down. In such situations they hope that they can make more money on the other routes to compensate.

With all of this to consider, the airline must be smart about how it manages it’s revenues as there are many ways in which it can lose revenue or not get the right mix between the profitable and non-profitable routes. These will be explored in the second part of this lesson.

Class will take a short recess before continuing with the discussion on Fares.

Airline Industry 102: SPVs (Special Purpose Vehicles)

The Airline Industry is notoriously volatile. The costs are high, the margins are low and airlines are exposed to a number of factors beyond their control. Among a myriad of things, airline operations are affected by weather, wars and conflicts, fuel prices, health issues like epidemics or even the eruption of an Icelandic volcano whose name you can’t pronounce. All of these factors can very easily, very quickly and very significantly affect the profitability of an airline. Bankruptcy is therefore always a real possibility.

In addition, Aircrafts are expensive to buy. A single 787, as an example, will cost about $200M (at list prices). Even a 737 will cost about $70-80M (at list prices). It’s, therefore, not a practical possibility for most airlines to buy their fleet using their own cash. The two main options are: a) lease the aircraft or b) borrow money from a lender.

The biggest risk hurdle that banks and financiers face in providing money to the airlines is Bankruptcy risk. A fundamental question they ask is “How can we ensure that if they go bankrupt, the aircraft will not be possessed by other creditors and deny us the opportunity to get part of our money back?” SPVs are the answer they have come up with to that question.

At its simplest, the SPV is a sort of holding company that will take ownership of the aircraft until the airline has finished the loan payments (typically 10-12 years after delivery). When the financial terms are agreed between the bank and airline, the SPV is created. At delivery of the aircraft, the SPV takes ownership of the aircraft and leases it to the airline. This way, if the airline goes bankrupt during the term of the loan, creditors can’t claim the aircraft as an asset of the airline as it technically does not belong to them. This makes it Bankruptcy Remote.

The lease payments made on a regular basis reduce the loan until it’s paid down (In very much the same way as a hire purchase transaction). Once the loan is paid, the SPV is unwound, and ownership of the aircraft is transferred to the airline.

Lastly, there is no naming convention for the SPVs. Some use the Manufacturer’s Serial No (MSN 12345 Ltd), others use a standard formula (XYZ 1 Ltd or XYZ 2 Ltd) and still others might chose the name of some thing local like the names of wildlife or a tourist attraction.

KEY POINT: The SPV exists to protect the lenders and that structure is used purely at their request.

This is the end of class 102 

Airline Industry 101: My first post

Welcome to Airline Industry 101. Class is now in session.

1. Aircraft decisions are always company decisions because of their magnitude – NOT management decisions. Therefore they are always referred to the Board of Directors (or equivalent) for approval. This applies when planes are bought AND when they’re sold. In fact buyers and sellers to airlines will insist on this. 

Summary: If it was bought or sold, the Board approved it.

2. The value of an aircraft is dependent on the condition of its maintenance and how much operating ‘life’ is left in its components. As the plane gets older (10 years and older) that value is almost entirely dependent on the maintenance condition of the engines i.e. how much operating life is left in them. In an aircraft that’s over 15 years old, the engines could easily be worth 90% or more of the value of the aircraft.

3. The operating life of an engine is measured in Flight Hours (number of hours in the sky) and Flight Cycles (a cycle being one take off and landing). It varies with how the airline operates the aircraft but as a rough estimate an engine will operate for 3-5 years after which it will need to be taken for overhaul. For an aircraft the size of a 737, the cost of one engine’s overhaul is between $3-6M depending on the work to be done.

4. For an older engine, straight out of an overhaul the value of the engine is roughly the cost of the overhaul.

Summary: As you use an engine, it’s value – and the subsequent value of the aircraft – reduces at roughly the rate of $2M per year ($1M per engine)

5. If you buy 2 aircraft with 2 engines each at approximately $24M in total, then for every year you operate the 2 a/c with 4 engines the value will reduce by about $4M. After 5 years of operations, the value of the aircraft can very realistically reduce from $24M (KES 2B approx) to $2-4M (KES 200M depending on exchange rate)

This ends today’s class. We shall reconvene at a later date. Until then questions are welcome.