EXECUTIVE INSIGHTS

VOLUME XVI, ISSUE 4

Reaching New Heights Together: How Airlines Can Maximize
the Value of Joint Ventu...
EXECUTIVE INSIGHTS
Figure 1
Understanding Airline Collaboration
Equity investment can occur throughout the
process, althou...
EXECUTIVE INSIGHTS

		 all traffic between North America and Europe, Africa,

		Market Example: The transatlantic JV betwe...
EXECUTIVE INSIGHTS
Figure 3
Historical Mechanisms of JV Agreements

Year

Partners

Current Mechanism

2009

A++ (Air Cana...
EXECUTIVE INSIGHTS
	 •	 Under what conditions, if any, will be the partner	 	 ship agreement be void (e.g., insolvency by ...
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Reaching New Heights Together: How Airlines Can Maximize the Value of Joint Ventures

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Airlines have long understood that trust is essential to their relationship with customers. Building trust between traditional competitors does not come naturally. The success of JVs depends on airlines’ ability to construct equitable and flexible partnership arrangements.

The pioneering partnership between Northwest Airlines and KLM Royal Dutch Airlines more than two decades ago ushered in an era of increasing collaboration among global carriers. More than 15 airlines now participate in immunized joint ventures. These JVs aren’t just happening between large global partners, but also between global and regional partners as large airlines seek access to growth markets and regional airlines pursue economies of scale.

L.E.K. Consulting Managing Director John Thomas and Senior Consultant Brett Catlin use research and market examples in this Executive Insights to help airlines seeking to maximize the value of joint ventures.

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Reaching New Heights Together: How Airlines Can Maximize the Value of Joint Ventures

  1. 1. EXECUTIVE INSIGHTS VOLUME XVI, ISSUE 4 Reaching New Heights Together: How Airlines Can Maximize the Value of Joint Ventures The ground-breaking partnership between Northwest Airlines We believe that deeper integration between JV partners of and KLM Royal Dutch Airlines more than two decades ago all sizes is inevitable, and that "virtual mergers" will become ushered in an era of increasing cooperation among global car- increasingly popular around the world. L.E.K. market forecasts riers. Once focused on modest collaboration such as selective suggest that by 2023, 45% of all global long-haul traffic will codesharing and reciprocal frequent flyer benefits, joint venture be part of a JV. With transatlantic markets largely mature, this agreements today have in many cases become so tight as to substantial growth is likely to come from increased collaboration be virtual mergers. Emboldened by the spread of Open Skies between developed and developing markets. In the case of Latin agreements, which provide the foundation for airlines wish- America, L.E.K. projects that well over half of the traffic bound ing to coordinate activities, a growing number of carriers are for North America will be linked to a joint business within 10 seeking the synergies of a merger even as they stop short of full years. How these partnerships are structured and managed unification. More than 15 airlines now participate in immunized will determine their success. In this paper, we highlight the key joint ventures. L.E.K. research suggests that such arrangements questions for airline executives and investors looking to capture were responsible for an astonishing 30% of all global long-haul the maximum value from joint ventures. traffic in 2013, up from only 9% a decade ago. In some cases, immunized JVs occur between large, global Building a Strong Foundation airlines, such as the recent market-disrupting tie-ups between Airlines have long understood that trust is essential to their rela- Qantas and Emirates, and Delta and Virgin Atlantic. In other tionship with customers. Building trust between erstwhile com- cases, executives for flagship carriers pursue JVs with regional petitors does not come as naturally. The longevity and success airlines to gain access to growth markets – a proposition that of JVs depends on airlines’ ability to construct equitable and appeals to regional airlines because of the economies of scale flexible partnership arrangements. In most cases, these arrange- offered by a global partner. Japanese carrier ANA’s recent ments will be founded on the principle of “metal neutrality,” purchase of an equity stake in Myanmar Airlines and Delta’s which dictates that revenue or profit is shared proportionally no innovative partnership with GOL are examples of such symbiotic matter which airline actually flies the passenger. Metal neutral- relationships between big and small carriers. ity helps align incentives and build trust. But the preservation of standalone value – that is to say, pre-deal financial performance – is also key to establishing confidence from the onset Reaching New Heights Together: How Airlines Can Maximize the Value of Joint Ventures was written by John Thomas, a Managing Director in L.E.K. Consulting’s Boston office, and Brett Catlin, a Senior Consultant at L.E.K. Consulting. For more information, contact aviation@lek.com. L.E.K. Consulting / Executive Insights INSIGHTS @ WORK TM LEK.COM
  2. 2. EXECUTIVE INSIGHTS Figure 1 Understanding Airline Collaboration Equity investment can occur throughout the process, although vested interest typically yields increased overall cooperation Fully independent (no collaboration) Airline has all the decision making power and does not share information with other airlines Interline Commonly achieved through alliances and low-level partnerships Codeshare Joint Venture Shared frequent flyer program, lounge access and coordinated schedules may be enabled early on through an alliance, or be achieved later on in conjunction with a joint venture; however, fare alignment and network optimization typically follows antitrust immunity (ATI) and is likely to be maximized following a joint venture agreement. Merger (full collaboration) Allows for full integration between carriers. Approximate percent of overall collaborative benefit realized: 0% 5% 65% 90% 100% Source: L.E.K. experience and analysis of negotiations. From this foundation, there are a host of Market Example: When Delta Air Lines and Virgin Atlantic potential considerations regarding the structure, mechanism executed their JV agreement in late 2012, they elected and governance for both parties to analyze and negotiate. to include all traffic between the United States, Canada and Mexico to London and to explicitly exclude substantial Determining the Right Structure Virgin Atlantic leisure traffic destined for the Caribbean. Determing the structure of joint ventures lays the groundwork • How will exclusivity be addressed? Will there be for all subsequent negotiations. L.E.K.’s experience suggests carveouts to preserve existing relationships? Will multiple that the most successful agreements focus on several key parties be permitted to operate on the same city-pairs? questions: • Which regions or routes will the partnership agreement cover? Will there be full metal neutrality for all of these routes? How will “behind” and “beyond” traffic be handled – that is, the connecting flights to and from the shared gateways? Market Example: When Air France, KLM and Delta formed a transatlantic JV, it included specific carveout provisions to capture and jointly account for connecting traffic from Los Angeles to Papeete and from Amsterdam to India. As a result, Delta and KLM split operations to India, with Delta exclusively operating to Mumbai and KLM exclusive ly operating to New Delhi. In contrast, the A++ JV between Air Canada, Lufthansa and United fully covers Page 2 L.E.K. Consulting / Executive Insights Volume XVI, Issue 4 INSIGHTS @ WORK TM LEK.COM
  3. 3. EXECUTIVE INSIGHTS all traffic between North America and Europe, Africa, Market Example: The transatlantic JV between American the Middle East and India. Airlines, British Airways and Iberia determined standalone profitability by using the 2008-2009 period as the baseline • Will service standards and selling practices be to the agreement, with a 15% allowance for codeshare aligned across carriers? Will fare buckets and pricing traffic which transits behind or beyond the gateway programs be integrated? airport. Market Example: Following the close of a JV deal between • Will there be a parity-payment adjustment (that ANA and Lufthansa, the two parties worked to simplify is, a payment from a poorer-performing partner fare structures and to harmonize joint selling. The unifica- to a higher-performing partner to make that tion resulted in ANA being able to competitively sell tickets partner whole) to address differences in baseline to 190 European destinations, up from 120 destinations profitability? How will the financial mechanism to prior to the agreement. protect standalone performance be structured? Deciding on a Partnership Mechanism • Which sources of revenue will be subject to the The most tenuous and time consuming portion of JV forma- cargo, etc.)? agreement (e.g., ancillaries, loyalty revenue, tion often involves determining how revenue or profit will be calculated and ultimately allocated. This is understandable: Figure 2 Negotiating an equitable mechanism to calculate and allocate Seats Falling Under JV Agreements, by Region (2003-23F)* the current and future performance of the joint business is criti- 50% cal given the permanence of the agreement. With that in mind, 45.1% 45% executives should ensure they thoroughly explore all options by 40% examining the following questions: 4% CAGR sharing or profit-sharing venture? Market Example: While the vast majority of JVs are structured as revenue-sharing ventures, Delta has execut- Percentage of Seats 35% • Will the joint enterprise operate as a revenue- 30.2% 30% 25% 29% 20% ed profit-sharing agreements for both of its transatlantic 15% joint ventures. While challenging to negotiate and imple- 10% CAGR ment, Delta decided that profit sharing ultimately ensured an optimally aligned incentive structure. 8.8% 5% 0% 2003 2013 2023F • How will standalone (i.e., baseline) profitability of each party be determined? How many years prior to Transatlantic Transamerica the agreement will be considered? Will adjustments be Transpacific E.U. to Asia permitted to account for irregularities? L.E.K. Consulting / Executive Insights Other Note: *Includes routes at least 2,500 nm in length with at least 52 flights p.a. Source: Diio Mi, L.E.K. analysis INSIGHTS @ WORK TM LEK.COM
  4. 4. EXECUTIVE INSIGHTS Figure 3 Historical Mechanisms of JV Agreements Year Partners Current Mechanism 2009 A++ (Air Canada, Lufthansa, United) Revenue 2009-10 Delta, Air France, KLM, Alitalia Profit 2010 American, British Airways, Iberia Revenue 2011 ANA, United Revenue 2011 American, JAL Revenue 2011 Delta, Virgin Australia Revenue 2012-13 ANA, Lufthansa, Austrian, Swiss Revenue 2013 Qantas, Emirates Revenue 2013 British Airways, Japan Airlines, Finnair Revenue 2013 Delta, Virgin Atlantic Profit Source: American, Delta, KLM, Lufthansa and Virgin Atlantic press releases; Examiner; Bloomberg; Financial Review; Business Traveller; L.E.K. analysis • For profit-sharing agreements, how will costs be allocated to the JV? What is the mechanism to deal Ensuring Good Governance with unilateral escalation in labor costs – for example, A good rule of thumb for establishing a strong governance if one airline is contractually obligated to increase pay for structure is for executives to hope for the best, but plan for the pilots and other flight staff at a certain date? worst; even the most amicable partnership can turn sour (and expensive!) in the face of unforeseen circumstances. Strong • Again for profit-sharing agreements, how will the governance can be established by addressing the following inclusion of certain assets, such as the introduction representative questions: of new aircraft or the purchase of slots, be account ed for in the agreement? • What is the length of the agreement? Will an ever green provision or termination penalties be included? • Will a proportionality clause be enforced to regulate capacity growth? How will any imbalance be addressed? Market Example: When Air France/KLM and Delta inked What is the mechanism to reduce shared capacity? an integrated agreement in May 2009, they favored a long-term, auto-renewing arrangement that can only Market Example: Over the past three years, while Air be canceled with three-years’ notice after a period of France, KLM and Delta have collectively withdrawn nearly 10 years. 3% of seats from the transatlantic market, the carriers relative split has remained stable at 45% (DL) and 55% landing slots at major airports and how are those has been enforced as joint capacity was rationalized. Page 4 • Who owns pooled resources such as takeoff and (AF/KL) – a strong indication that a proportionality cause resources managed by the JV? L.E.K. Consulting / Executive Insights Volume XVI, Issue 4 INSIGHTS @ WORK TM LEK.COM
  5. 5. EXECUTIVE INSIGHTS • Under what conditions, if any, will be the partner ship agreement be void (e.g., insolvency by one party)? Looking Toward the Future As the model matures, airlines may pursue further opportunities to monetize the assets of the JV to the benefit of shareholders. • How are approval and/or veto rights structured For instance, executives may choose to spin-off the JV portion for major decisions? What is the protocol for resolving of their business in an IPO – a bold strategic move similar to the disputes? loyalty program spinoffs undertaken by Air Canada, Aeromexico and others over the past decade. Such a structure would enable • What is the process for terminating the partnership? the asset to be independently valued, while providing investors If liquidated damages or other remedies will be required, with the ability to invest in a specific region or route system. how will they be calculated? How do you structure an agreement that permits minimal disruption should that Whatever course they take, we expect immunized joint ventures agreement fall apart? will continue to gain favor across the airline industry. Our forecasts suggest that in 10 years nearly half of all long-haul traffic will be carried by an airline participating in a JV. How much value such partnerships bring to industry stakeholders will depend in large part on how the questions raised in this paper are addressed. INSIGHTS @ WORK L.E.K. Consulting is a global management consulting firm that uses deep industry expertise and analytical rigor to help clients solve their most critical business problems. Founded 30 years ago, L.E.K. employs more than 1,000 professionals in 22 offices across Europe, the Americas and Asia-Pacific. L.E.K. advises and supports global companies that are leaders in their industries – including the largest private and public sector organizations, private equity firms and emerging entrepreneurial businesses. L.E.K. helps business leaders consistently make better decisions, deliver improved business performance and create greater shareholder returns. For further information contact: Boston New York 75 State Street 19th Floor Boston, MA 02109 Telephone: 617.951.9500 Facsimile: 617.951.9392 1133 Sixth Avenue 29th Floor New York, NY 10036 Telephone: 646.652.1900 Facsimile: 212.582.8505 Chicago San Francisco One North Wacker Drive 39th Floor Chicago, IL 60606 Telephone: 312.913.6400 Facsimile: 312.782.4583 100 Pine Street Suite 2000 San Francisco, CA 94111 Telephone: 415.676.5500 Facsimile: 415.627.9071 Los Angeles 1100 Glendon Avenue 21st Floor Los Angeles, CA 90024 Telephone: 310.209.9800 Facsimile: 310.209.9125 TM International Offices: Bangkok Beijing Chennai London Melbourne Milan Mumbai Munich New Delhi Paris São Paulo Seoul Shanghai Singapore Sydney Tokyo Wroclaw L.E.K. Consulting is a registered trademark of L.E.K. Consulting LLC. All other products and brands mentioned in this document are properties of their respective owners. While L.E.K. advised the parties cited in a number of the examples, all data are sourced from publically available records. © 2014 L.E.K. Consulting LLC L.E.K. Consulting / Executive Insights INSIGHTS @ WORK TM LEK.COM

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