Asia on track to meet growth expectations, but...

This week saw the annual assembly of presidents of the Association of Asia Pacific Airlines, this time in Seoul.

In a briefing to journalists prior to the main business of the big event, the AAPA's director general Andrew Herdman (pictured) shared his perspective on the state of the industry in this region:

2010 was a great year for aviation after two very, very difficult years of recession. We had a big strong result in 2010, the industry made about US$18 billion; but that was still only about a three per cent profit margin for the industry in a good year.

Asian airlines contributed about half that result, so it was a particularly good year for Asian airlines which had profit margins of around six per cent on average. The reasons for that were that we saw a rebound, passengers came back, cargo came back hugely which obviously benefits big Asian carriers which are very dependent on cargo, and oil prices were in the $80-ish range. That all translated to record load factors…

Going into this year the outlook was reasonably positive and indeed the global economy kept growing during the first half. Year to date passenger numbers for Asian airlines are up again about four per cent, but cargo’s down about four per cent from the peak of last year.

Nobody anticipated this particular outcome, so planned capacity grew for passengers grew slightly faster than the actual growth in demand; and on the cargo side, initially capacity grew even as traffic was falling back slightly from the levels of last year. So as a result load factors fell, pricing power diminished and meanwhile, blind to the fact that the global economy wasn’t in that good a shape, oil prices kept on rising. So we are now in a situation where oil prices are 40 per cent up on last year… and the airlines have not been able to pass on that higher cost, and airline margins have therefore been squeezed significantly worldwide…

The mood in the second half has been quieter, although Asian economies are still growing relatively robustly, and that’s reflected in intra-Asia traffic both leisure and business, we have seen weak cargo demand particularly for exports.

Overall the outlook for 2012 should be reasonably positive, particularly if you’re sitting in Asia, but the short-term sentiment is anything but and that’s where the uncertainty for 2012 lies.

We are still exceedingly bullish about the industry. There is a collective confidence and optimism about the future and that’s reflected in the way Asian airlines are ordering equipment, investing in customer service innovation etc.

At the same time the low-cost segment, price-sensitive travel, is growing; and clearly the dedicated single-class narrow-body operation is optimized to serve that segment.

And so you see a lot of airlines beginning to set up subsidiaries, associates, to serve that segment using the traditional LCC model. Qantas demonstrated with Jetstar the way in which that could be executed, a distinct brand, a distinct differentiated cost structure, and yet tightly coupled strategically with the development of Qantas as the parent company. The challenge for anyone else trying to set of a low-cost operation will be to try to emulate that…

It should not however be assumed that the secrets are all known, there’s still an element of experimentation in this.

In Asia you can’t do cross-border mergers, so what we are seeing is a lot of fertile thinking and experimentation. And most recently of course we’ve see hybridization, which is exactly the word when a full-service carrier teams up with a pedigree low-cost carrier to form a joint venture. In Japan we’ve seen two, with All Nippon with AirAsia and JAL with Jetstar.

We are seeing a lot of innovation like this, at the same time as the full-service network carriers still have a lot of confidence in the full-service model and are still investing very heavily in making sure they stay competitive, particularly in business class.

The convergence argument is over. It’s clear that in long-haul it’s about multiple classes, it’s about market segmentation, it’s a question of choosing the right spot for pitching the front end, how you price it and what the right configurations are.

Where’s the revenue going? The major carriers still capture a huge lion’s share of the revenue. The LCCs in Asia have captured maybe $5 billion out of perhaps $100 billion plus. So the LCCs are expanding into long-haul because it’s where the ASKs are, it’s where revenues are. The LCC market is a finite market where growth is already slowing in Europe which a long way up the curve. The market still has a long way to go in Asia in terms of LCC penetration but it’s still limited.

This is why the network model is still alive and well and yet its still makes sense to invest in different segments. It’s a question of tuning the way you serve the market in terms of differentiating cost.

Most of this activity is designed to differentiate cost more than it is to position brands to appeal to different customer segments. People don’t choose the airline based on being in love with the brand, they are looking for what offers best value. They are just as happy to buy aggressively priced tickets from full-service carriers. And they’ll shop around to see what they will get if they fly at the front end of a Jetstar long-haul.

If you look at the projections of capacity, they’ve grown pretty much in line with demand. Historically the load factor for this industry used to be decades ago just over 50 per cent, then it was 60s to be efficient then 70s; and now you’ve got to be in the 80s. The efficiency of the industry has been growing and that’s because of aggressive yield management. If you fix your prices you’ll have a lot of empty flights; if you want to maximize utilisation you’ve got to be very aggressive about dynamic pricing. And when load factors have been going up like they have then it’s hard to argue that there’s a capacity overhang.

It sounds like the fundamentals are pretty much all in place, which should serve Asai Pacific well whatever challenges 2012 may bring.

But the experimentation with 'hybridisation' should ring some alarm bells. Not all of those experiments are going to meet the expectations and there will be significant losers, particularly when China flexes its largely dormant muscle and starts to shape the industry to its own whim.