Airline joint ventures face big operational challenges

By Michael Fabey

Melding pointJoint ventures are transforming the global aviation industry by creating virtual airline mergers, avoiding the costs and legal challenges inherent to actual consolidation.

Empowered by antitrust immunity within the three major airline alliances and emboldened by the growing strength of the first transatlantic and transpacific joint ventures, carriers are now looking for ways to leverage expanded economic relationships to revamp networks, increase traffic and boost revenue.

Atlantic routes are leading the way. American Airlines and British Airways began operating their immunized partnership with Iberia last month.

The Star Alliance recently added the Continental network, now part of United. And the joint venture of Delta and Air France-KLM has begun to flex some muscle with recent corporate sales contracts designed to capitalize on the reach and capacity of its member carriers.

In the Pacific, meanwhile, immunized joint ventures are just getting off the ground. Japanese regulators last month approved one partnership involving Japan Airlines and American and another between All Nippon Airways and United. The U.S. Department of Transportation said earlier this year that it, too, intends to approve the request.

Still, many industry experts say the airline joint ventures face significant challenges. Winning over regulators in the U.S., Europe and Japan might turn out to be the easy part of melding their international operations.

Far more daunting are the challenges of marrying disparate computer systems for booking, billing, scheduling and financial operations, which will be essential to actually realizing the increased revenue they have promised stockholders and the service improvements they have promised regulators.

"There's been a whole series of approvals across the Atlantic and the Pacific," said Dwayne Ingram, executive vice president of Amadeus Americas. "And that's going to create a whole new wave of different issues. What happens when you have a different codeshare partner? How do I make that experience the same?"

He cited the growing importance of ancillary fees as an example, pointing out that when Delta and Northwest merged, neither of their booking or billing systems were capable of handling unbundled services. Now that Delta is in a transatlantic alliance with Air France-KLM, he said, the newly merged carrier faces not only the challenge of building a system that can handle ancillary fees but one that interfaces smoothly with the Air France-KLM systems.

"Are they going to try to get it all in one leap?" Ingram wondered.

Until recently, joint ventures and the overarching structures of airline alliances have served to brake the momentum toward collecting additional fees and building up ancillary revenue, said Jay Sorensen, president of the IdeaWorks consultancy and author of the annual Ancillary Revenue Guide.

Moreover, differences among airlines in what services they charge for and in the levels of the fees they charge have until recently prevented joint-venture and alliance partners from agreeing on an overall strategy. Now, Sorensen said, the partners are starting to get on the same page regarding ancillary fees.

"When an alliance agrees on a particular policy, it moves rapidly ahead," he said.

Making more money, after all, is what joint ventures are all about, and that might prove to be a significant challenge.

VAUGHN CORDLEVaughn Cordle, an analyst with the AirlineForecasts consultancy, observed recently: "Over and above the benefits of [joint ventures], fares will have to increase materially if the airlines are to move toward the rate of return that is required to sustain shareholder support while at the same time paying down debt and building equity via retained earnings."

Such fare increases would likely strike a sour note with the U.S. Transportation Department, which will review joint ventures every 18 months to determine if the partnerships are working as airlines promised they would. Cordle said there "are no guarantees" that the joint ventures will still be immunized after the reviews are completed.

In recent years, though, antitrust-immunity requests for joint-venture partnerships have found favor with government regulators. In the U.S., the DOT has stated that immunized ventures are necessary for airlines to compete fairly in the international marketplace and offer passengers the widest range of choices for the lowest fares to fly, as the DOT has phrased it, "from anywhere to everywhere."

That viewpoint, however, is not shared by all the players in the industry or in government. ASTA, the Justice Department and U.S. Rep. James Oberstar (D-Minn.), the outgoing chairman of the House Transportation and Infrastructure Committee, have been particularly vocal in their objections to the concentrated market power being handed over to the airlines and their alliances.

ASTA and several other industry organizations have predicted that the joint ventures will reduce travel distributors' bargaining power, marginalize independent distribution through commission reductions, withhold capacity and increase fares.

The Justice Department predicted immunized partnerships would be able to increase fares by as much as 15% on key routes in the markets they control.

James OBERSTAROberstar, who was defeated in his re-election bid last week, has said that the resulting market dominance will be significant. Combined, he noted, the Star, SkyTeam and Oneworld alliances account for almost 80% of global passenger capacity, 78% of traffic and 73% of passengers. In all, Oberstar said, the three alliances control more than 87% of the traffic between the U.S. and Europe.

The DOT has responded that high market shares do not necessarily translate to higher fares. The agency says it's in the immunized airlines' best interest to attract traffic by offering competitive fares.

As for agents and the GDSs, the DOT argues that they will also benefit because the joint ventures will want to embrace distribution channels as much as possible in their operations.

Further, the DOT says the alliance structure, including the various joint ventures, has evolved as a consequence of market pressures and political realities. Protectionist measures in the U.S. and other countries prevent foreign entities from buying or investing too heavily in other nations' airlines. The only means the carriers have to establish international networks, the DOT argues, is to establish alliances.

The DOT further argues that while codeshare and similar agreements help airlines develop relationships on certain routes or markets, such deals fail to provide the breadth and depth of interaction required to provide true joint services.

Darryl Jenkins, founder of the aviation economics website the Airline Zone, begs to differ. "A joint venture is a business arrangement, a kind of a virtual merger," he said. "They're acting on routes as if they were merged."

The DOT's key criterion is "metal neutrality," meaning that no matter which airline carries the passengers, the revenue is shared by the members, allotted according to the capacity they contribute to the mix.

In its approval of the Star and Oneworld immunity requests, the DOT wrote that alliance-member carriers "are indifferent as to how they price, market, revenue-manage, promote, distribute and sell any international passenger itinerary traveling over the alliance network, irrespective of the airline operating the flights."

Or, as Wall Street analyst Bob McAdoo of Avondale Partners said, "All of the carriers in the joint business are motivated, irrespective of whose airplane it is, to drive more passengers in any cabin of business to expand the pot and, most importantly, to stop trying to take passengers from each other."

Another proponent of joint ventures is Loren Aandahl, who was one of the Northwest managers responsible for creating the industry's first joint venture, with KLM.

"All revenue and expenses are put into the pot," said Aandahl, who worked at Northwest from 1991 to 2007, mostly in the international and planning group and for the last eight of those years as managing director of international planning and scheduling. "What came out, the profit, was split 50-50. The [joint venture] was incredibly profitable -- people could not believe how profitable; it was by orders of magnitude."

American Airlines executives described a similar revenue-sharing scenario with joint-venture partners.

"We share proportionately in terms of revenues," American's CFO, Bella Goren, told Wall Street analysts in October. She explained that the revenue sharing is based on the passenger capacity that each member airline contributes to the venture, "but we are indifferent as to whether the customer chooses a seat on BA or American or Iberia."

American has already initiated some aspects of its joint business with British Airways and Iberia in marketing services, selling through direct channels and coordinating prices, she said.

Gerard ArpeyAmerican CEO Gerard Arpey told analysts that the three airlines' relationship changed "dramatically" on Oct. 1, when the joint venture officially started.

"While we have been great [alliance] partners for many, many years, we have also been ferocious competitors," Arpey said. "We orchestrated that partnership around the fact we didn't want people riding on BA to London, nor did they want anybody riding on American to London. We had all kinds of head-hurting restrictions or outright elimination of codesharing and frequent-flyer benefits, because we did not want to see any of our traffic diverted to BA or their traffic diverted to us.

"That ended Oct. 1. We now really do have a partnership, where our economic interests are aligned to take business not from each other but from the other guys. We started codesharing on numerous additional routes. We have realigned our own schedules and expanded our service to hubs in Budapest and Helsinki."

That kind of arrangement has been embraced by other joint ventures, as well, and it has worked for the airlines involved.

"On a year-over-year basis, Continental's third-quarter total partner revenue was up about 83%, due primarily to its membership in Star Alliance and the implementation of many aspects of its transatlantic joint venture with United, Lufthansa and Air Canada," Jim Compton, executive vice president and chief revenue officer for United, told analysts.

Not surprisingly, Star made its transatlantic joint venture agreement the "template" for its Pacific agreement with JAL, the carriers told the DOT.

In its recent joint-venture approvals, the DOT said that going forward, the best way to ensure competition would be to keep the alliances on even footing, and the best means to accomplish that would be to make sure that certain core members in the different airline alliances develop similar immunized joint ventures.

airline alliance market sharesFor example, in granting Oneworld's request earlier this year, the DOT said it was simply leveling the competitive landscape with the rival SkyTeam and Star alliances. (Click on the image for a larger view of a chart of airline alliance market shares.)

"Oneworld becomes a strong, third-alliance competitor," Susan Kurland, assistant secretary for aviation and international affairs, wrote in the DOT order. "Consumers getting a third viable option will enjoy more destinations, better connections, improved schedules and better frequent-flyer benefits."

Few doubted that the DOT would grant the request, especially since in September 2008, Ray LaHood -- then a Republican congressman from Illinois, now transportation secretary-- had sent a letter to then-Transportation Secretary Mary Peters asking the DOT to grant the Oneworld request in order to "help them to compete with Star and SkyTeam."

Analysts like Richard Aboulafia, vice president of the Teal Group consultancy, say that once SkyTeam and Star airline members had their immunized transatlantic joint ventures, the DOT and other regulators had little choice but to approve a similar request by Oneworld, even though requests for immunity by American and BA had been denied twice before.

Once the transatlantic services were immunized, analysts say, it seemed only a matter of course before the trend expanded to transpacific routes.

Japan pushed matters along by making antitrust immunity for its national airlines and their partners a condition of the open skies agreement it signed last month with the U.S. The DOT considers such open-skies deals to be prerequisites to joint-venture approvals.

airline joint ventures and routesThe only recent joint-venture request to face DOT opposition was one proposed by Delta and Virgin Blue between the U.S. and Australia. Last December the two airlines won approval from the Australia Competition and Consumer Commission for their joint venture, but the DOT said in September that the airlines had failed to demonstrate sufficient public benefits to justify antitrust immunity. (Click on the image for a larger view of a chart of the airline joint ventures and routes.)

Delta and the Virgin Group are trying to persuade the DOT to reconsider its position.

Many analysts say the DOT and other countries' regulators should rethink the approvals they have granted for immunized joint ventures. AirlineForecasts' Cordle, Amadeus' Ingram and others in the industry have noted that the infant joint ventures have yet to truly stitch together their systems and networks to prove they're capable of delivering on promised additional revenue and service improvements.

Julia Sattel, vice president for airline information technology at Amadeus, observed that "as long as [the member airlines] have different bottom lines, it's harder to come to mutual goals."

Likewise, Cordle cautioned: "Revenue synergies are likely overstated. The arrangement may not be sustainable in the long run if one or more of the partners are disadvantaged in terms of returns and growth."

And former Northwest executive Aandahl wondered: "With United, Lufthansa and Air Canada, are people there really going to take steps to reduce costs? I put in a lot of my time reducing the cost of operations and running the business more efficiently. At some point in time, do these three groups become anticompetitive?"

Cordle flatly predicted, "Revenue synergies will be competed away as the partners attempt to capture larger market shares via lower fares and more seats."

Moreover, the airlines themselves, even at this early stage, have come to realize that joint ventures are not a panacea.

United CEO Jeff Smisek had to explain to Congress this spring why he wanted a merger between United and Continental this year when last year he had said Continental would be fine without a merger if it secured an immunized joint venture through Star. After the joint venture was approved, he explained to legislators, "We were hoping the Star Alliance would be sufficient to return us to profitability."

Instead, Continental posted losses through early 2010, reporting a $146 million loss in the first quarter, though it earned $354 million in net income in the third.

United's Compton warned analysts last month to expect a $100 million expense through the first nine months of this year because of revenue-sharing payments it must pay its joint-venture partners.

When analyst Glenn Engle of Bank of America Merrill Lynch questioned the liability cost, Compton explained that it included Continental's revenue from its relatively new entry into markets through Star and the joint venture.

It remains unclear how the joint ventures will interact with corporate clients or other parts of the distribution channels.

Delta and Air France-KLM last year started joint sales contracts for "trade and corporate partners," including travel agents and large business travel accounts, across Europe to "ensure commercial efficiency." The airlines haven't disclosed details of these claimed benefits, either financially or operationally, for the airlines or their customers, other than to say the deals offered a single point of contact for 710 weekly transatlantic flights.

Travel agents say they are concerned about how joint ventures might affect competition or costs for international corporate customers.

In response to such concerns, the Star joint-venture members say they started offering incentive payments and commissions last year to selected agents for "preferentially" selling flights on their combined network. The airlines also say they offer corporate travelers a simpler, single-contract option, more competitive discounts and the ability to qualify for more volume discounts on all participating airlines.

The ultimate question for the joint ventures, Cordle said, is what will happen when they all start battling for the same passengers in the same markets to get the kind of traffic counts that will be required to make the deals worthwhile. "Competitors -- especially competitors in other alliances and [joint ventures] -- are not going to roll over and cede market share without a fight," he said.

While that's precisely what the DOT is aiming for, Cordle warned there's only so much revenue to go around in any given market. What was enough for one joint venture, or even two, might not be enough to support three or more.

What will happen then, analysts and others predict, is that the partners will likely raise fares, raise or add ancillary fees and come up with other revenue streams.

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