Airlines and Capital: Ownership Questions Loom

Posted by: Justin Bachman on February 20

Last year, the Open Skies Treaty between the U.S. and European Union opened new routes across the Atlantic. The first phase dealt with liberalization of so-called “cabotage,” the rules that outline who can fly where. While once an airline could fly from its home country to a few spots in the U.S., and vice versa, the new rules allow airline route planners to deploy planes pretty much where they see fit. That’s why Air France tried, briefly, a daily nonstop from Los Angeles to London, never touching France, and why so many U.S. carriers started flying to London’s Heathrow Airport the very first day they were allowed to land there. Cabotage was a goal mainly for U.S. airlines; the Europeans assented to first-round concessions, with an eye toward a larger prize.

And that time is drawing near, in about a year. The Europeans are prepared to lobby vigorously for the part of Open Skies they see as far more crucial: relaxed ownership rules. In 2010, a year that will likely inflict further financial stress on a global airline industry struggling under recession, expect a new push to soften the 25% cap the U.S. imposes on foreign investment in airlines. It’s no secret to anyone that among the developed world’s airlines, U.S. carriers are the unfortunate, pitied cousins, their service and finances both in shocking disrepair. Most U.S. airline executives would welcome a strong financial partner, or the ability to sell out to one of them. And Europeans want greater access to fly domestic U.S. routes and to acquire airlines here.

Financially, the world’s airlines are at a critical crossroads and some fundamental decisions must soon be made. The Open Skies treaty is likely to be the immediate venue, with the needed upgrades to America’s aviation infrastructure the larger investment backdrop. This was the central thrust of the message delivered by Giovanni Bisignani, director general and CEO of the International Air Transport Association, the Geneva-based trade group for 230 of the major passenger and cargo carriers. Bisignani stopped by BusinessWeek’s offices Feb. 19 to chat before his speech at the Wings Club.

He and others argue that it is time to operate airlines as true businesses with decent profit margins and returns on capital – or else turn them into government services “like a bus,” Bisignani says. Why now? The industry claims it has become a rational enterprise, ruthless and disciplined, in the eight years since the 2001 terror attacks forced radical change. Costs and capacity have been shed; wasteful ways are verboten. So while the managers and operations are now professional, like any other well-run business, according to this line of argument, airlines’ return on investment is nil. As of 2008, the industry’s historical profit margin amounted to 0.3%, Bisignani says, while most U.S. carriers register negative margins. (Even Southwest’s profit margin is only 1.6%, compared to Microsoft’s 28% and Merck’s 33%.) A return of 7%-8% is needed just to cover the capital costs, Bisignani said. One reason for this situation is that the industry remains so fragmented. It may be great having dozens of daily nonstop flights between New York and London on (currently) seven airlines, but that’s a real mess if you’re hoping to turn a profit. “We are a piece of a value chain and it’s the only piece that loses money,” he said. To that end, the airlines are hoping to loosen the restrictions on global capital.

Bisignani, a Harvard Business School alum and former Citi banker, argues that passengers will benefit, since service would almost certainly be better. “Wouldn’t fares have to be higher to satisfy an Air France KLM’s or Lufthansa’s financial goal if they ran a U.S. operation?” I asked. He thinks more people would be spurred to fly, allowing volume to keep fares affordable. I think the government would also be urged to subsidize some routes, much as it does now for Alaska and other rural areas.

So what would need to happen? The unions would almost certainly need ironclad guarantees that jobs would be retained. Politicians would assuredly require certain flight levels be maintained outside the urban areas. (“Yes, Richard Branson, we are in Kansas anymore.”) And if this actually comes to pass, I think many of us will need to further disabuse ourselves of the idea that a bargain fare can always be found: Bargains are the enemy of a decent profit margin. Europeans still pay more than Americans for their full-service airlines. The hard truth is that running an airline industry like a “real business” is going to require the clients to pony up more.

Bisignani argues that the ownership rules are a ridiculous relic of the 1940s, when commercial aviation’s safety and security protocols were in their infancy. The ownership rules also rest upon the notion of a big network airline as a globetrotting symbol of a nation’s greatness. Think British Airways, Qantas, American, Air France, etc. The flags say something about who we are. Or, perhaps more accurately, they served this function at one time. “The flag on the tail of the airplanes are killing this industry!” says Bisignani, his eyes flashing a mix of mirth and sincerity about the point.

Another argument used for the status quo is security. However, today numerous governments electronically scrutinize each inbound passenger before the plane on which we sit even pushes back from the gate. Still, plenty of earnest, sincere people would be nervous about citizens of another country owning and operating an airline assembled from the gutted overhaul of a United or US Airways. It would be a huge change, never before done. However, 11 years ago a pillar of German industry, Daimler AG, acquired one of the Big Three Detroit automakers, with the only resulting damage suffered by Daimler shareholders. And that pioneer of American technical prowess, IBM (IBM), sold its entire consumer PC business to the Chinese. Bisignani argues that the so-called invading foreigners isn’t truly an issue, once a deal is done, and points to the experience of Lufthansa. That airline now owns the former Belgian, Swiss and Austrian flag carriers, as well as a large U.K. airline, bmi, and is launching a new domestic operation in Italy. Lufthansa also owns 19% of JetBlue and would likely expand that stake if it were allowed. “In Europe, I think we have come to understand that the business has to be run in a business way,” he said.

So, the question arises: Should we welcome or fear the prospect of domestic air service from European or Asian companies? Cars, clothes, and telephone service are heavily controlled by non-U.S. entities. Is an airline different? “Passengers don’t care who owns an airline so long as it is safe and provides efficient service,” Bisignani said in his speech, which you can read in its entirety here. “What is different about aviation?” he asks, before answering “absolutely nothing.” It’s a good question. And the U.S. may soon have to answer it.