Determinants of Airlines Profitability: An Analysis of Air Algeria

Introduction..........................................................................................3
1. Airlines Profitability.............................................................................3
1.1 In the macro and micro view........................................................3
1.2 Microeconomics concept.............................................................4
1.2.1 Pricing decision....................................................................5
1.2.2 Aircraft acquisition................................................................6
1.2.3 Output decision. ..................................................................6
1.2.4 Choice and opportunity cost.....................................................7
2. Determinants of Airlines profitability........................................................7
2.1 Measures of Profitability in the Airline Industry ..............................10
2.1.1 Operating Ratio ...................................................................10
2.1.2 Net Profit Margin ....................................................................................10
2.1.3 Return on Invested Capital (ROIC)...........................................10
2.1.4 Return on Equity (ROE)............................................................10
2.2 Determinants of profitability.........................................................11
2.2.1 Net Profit............................................................................11
2.2.2 Efficiency............................................................................11
2.2.3 Load Factor.........................................................................11
2.2.4 Pricing................................................................................12
2.2.5 Daily Aircraft Utilization.........................................................12
2.2.6 Employee Productivity............................................................13
2.2.7 Leverage..............................................................................13
2.3 The airline's profitability main issues...............................................13
2.3.1 Unprofitable Airlines continue to fly...........................................14
2.3.2 High fixed and variable cost......................................................14
2.3.3 Aggressive price Competition....................................................14
2.3.4 Exogenous events..................................................................15
2.3.5 Reputation for hassles and poor service.......................................15
3. Methodology versus data........................................................................15
3.1 Model Variables.........................................................................16
3.2 Performance Earning Ratios.........................................................17
3.2.1 Net profit margin..................................................................17
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3.2.2 Operating ratio.....................................................................17
3.2.3 Return on equity (ROIC).........................................................17
3.2.4 Return on equity (ROE)..........................................................18
3.3 Source of Data ...........................................................................18
4. Quantitative data description...................................................................19
4.1 Financial structure of Air Algeria ...................................................20
4.2 Return on Capital Employed (ROCE).............................................21
4.3 Return on Assets (ROA)...............................................................21
4.4 Fixed Assets Turnover.................................................................21
4.5 Coverage interest Ratio ................................................................22
4.6 Net Margin, Operating ratio and Return on Equity (ROE)...................22
4.7 Load factor..............................................................................23
4.8 CASK and RASK...........................................................................23
4.9 Ratios Analysis .................................................................................................23
4.9.1 Ratios Analysis Summary...........................................................................24
5. Qualitative Determinants by the airline industry.........................................24
5.1 Foreign exchange risk.................................................................25
5.2 Fuel cost..................................................................................26
5.3 Labor cost................................................................................27
5.4 Challenges..................................................................................28
References.............................................................................................30
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Introduction
This study aims to demonstrate the options to analyze the profitability of the enterprise in the
macro and micro environment particularly focusing on the growth of airline Air Algeria. The major
goal of the assignment is to offer them alternatives to increase their performance based on the
rationale and methodology that will be chosen during the study. In December 2017, the International
Air Transport Association (IATA) which represents over 280 air carriers spoke about the profitability
estimates for 2018. According to Bottom Line (2017) strong profitability which was reported in 2017
would continue into 2018 yielding an estimated $ 38.4 billion globally. However, in the month of June
of 2018, IATA announced that the profitability of world’s biggest airlines headed for a dip. The
determinants of Aviation Profitability and the stated reasons that make profitability fall will be
addressed in the next chapters.
1.4 The Airline industry overview
Aviation began early in the 20th century and entered the modern age after WWII. It has become a
trend toward deregulation in 1978 and turned into a mass market product that disseminated
internationally ever since. Airlines are a tool for economic development, it is an industry that is
essential to the economic system of the modern age. The airlines must follow the safety regulations
(EASA, FAA, ICAO, and IATA), environmental regulations and airport restrictions. In the Airlines,
there are many different stakeholders as: passengers, employees, airports, financiers, suppliers,
governments, air navigation providers, marketing partners, etc.
The major characteristics of airline industry are:
 Commercial systems
 Booking and reservation systems
 Revenue and pricing management
 Customer management
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 Social media
 Scheduling systems
It is a business where losses are more certain than profits and shorts are the usual occurrence.
Everyone who dreams about starting an airline is aware of such risks, yet there are always
entrepreneurs, who are eager to send them aloft and investors willing to gamble on the venture. They
are driven by the very human aspiration to succeed where others have failed
The systems to management, planning and control:
Flight Operations systems:
 Crew planning and scheduling
 Flight planning; OCC: (flight tracking; hub control; weather)
Airport systems:
 Departure control (check-in, load sheet, weight and balance)
 Airport flight information and customer systems
 Maintenance planning and control
 Financial systems and accounting
In such market, where equipment is very expensive, inventory can be spoiled every time a
flight takes off with unsold seats. So, the bottom line is very vulnerable to GDP growth due to several
reasons including the price of fuel. With relatively minimal profit margins, the financial condition of
the airline industry is highly dependent on global economic conditions. During the times of economic
boom, profits soar and in times of recession airlines are forced to reduce capacity. Prior 1978, the
industry was relatively stable based mainly on the government's enforcement of non-competitive
regulation and pricing. In the post-deregulation era, the industry took on more cyclical nature of a
sector industry, where periods of financial results could be followed by a turbulent economic period.
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The financial condition of the air transport industry is relevant to the economic growth, so it is
therefore not surprising that the airline industry suffered when the economy stalled. Before
deregulation, domestic traffic was organized according to the rule established by each country. For
each country, the local authority was responsible to determine how carries should choose their routes
and specify capacity each approved carrier could offer on each route along with fares to be charged. In
the United States, the Civil Aeronautics Act of 1938 was introduced to regulate and control
competition between US domestic’s carriers. Uncontrolled competition had led to anarchic economic
conditions, little security to investors and low safety margins. Three arguments were used to justify
the implementation the Civil Aeronautics Act of 1938. The first one was about the absence of any
regulation of market entry, which would lead to a destructive competition. The fact that the industry
has non-differentiated product and relative low barriers for new entrants, the small new entrant airlines
would not have a cost disadvantage when competing against much larger incumbents. These new
entrants into particular market would try to establish themselves by under-cutting existing fares, which
certainly causes price war with dramatic consequences for the air transportation industry. The second
argument favoring regulation was that air transport is a public utility, arising economic, social and
political benefits. Hence, regulation is more than needed in order to ensure that the benefits were not
endangered. The public utility of air transport was considered significantly important that most
countries except the United States launched their flag carriers with direct government participation.
"The same carrier often operated domestic services and acted as the designated foreign carrier, it
was a natural extension of this point of view to believe that free and unregulated competition on
international air routes would endanger national interests because it might adversely affect that
national state owned airlines" (Doganis 2010).
The third argument was about supporting regulation of international air transport, rapid
development of charter flights. It further was argued that scheduled traffic was relatively thin for even
a small loss of traffic and this might jeopardize the continuation of scheduled operations.
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During the 1960s, economists began to question the benefits of regulation and argued the
advantages of deregulation and free competition by explaining existing regulation limited pricing
freedom, restricted capacity growth and excluded new entrants. If deregulation was implemented, a
more competitive environment would provide more benefits to the consumers in terms of fares. Some
inefficient airlines would be forced to leave some market or even the industry. Similarly, lower fares
would force the airlines to review their costs and to improve their efficiency and productivity.
Economist Iatrou and Oretti (2007) explained that the airline industry was not different from
the other industrial and service sectors, so neither the airlines nor the consumers needed special
protection, and the anti-monopoly regulation is sufficient to protect the consumer interest. If due to
bad management the incumbent airlines went bankrupt, others would position in the market. In 1978,
the newly elected president Carter, who made support for consumers a key part of his election
platform, signed the Airline Deregulation Act into law on 24 October. This set off a chain of events
which over the next 30 years were to transform international air transport from a protected and highly
regulated industry into one which is more truly open and competitive industry (Stephen Shaw 2010).
The deregulation came to Europe more than 10 years later. Right before the deregulation introduction,
European air transport was dominated by state owned carriers or flag carriers. Due to the protection
from their respective government, their networks were immune to competition. Consequently, some
airlines had seldom recorded a profit during their entire existence relying fully on government
subsidies.
In 1987, the European Commission introduced its three phase’s ten- year’s reform process. The EU
airlines were gradually granted rights to operate on any route in the EU, including flight wholly within
another country (Cabotage). In late 1992, the European Union (EU) had passed legislation
deregulating the airline industry. By January 1993 the European airlines had free access to all
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international routes in the EU and set their own fares. The step following the deregulation Act was the
open skies agreement.
In 1993 the US and the Netherland Government negotiated an open sky agreement followed by
a large number of agreement between the US and others Governments. Allowing each side designate
the number of airlines; so, these airlines are then free to fly to any city with no limitations on their
capacity and pricing decision.
Following the increasing number of air services agreement between individual European
countries and foreign countries, the European Court published a judgment on 5 November 2002. The
Court considered that any individual member governments of the European Union offended against
EU competition law if they signed Air Services Agreements with other countries that limited the use
of traffic right purely to airlines were owned and controlled by their citizens.
Such rights should had potentially to be available to all EU airlines. If they were not, such
discrimination was an infringement of the competition articles in the Treaty of Rome. The outcome of
this judgment was a completely new system, the European Commission would take over the
negotiation of external aviation relationship with other countries on behalf of all EU members’ states.
In less than 30 years, from 1992 to 2010, the airline industry had known an amazing change,
many of the airlines that dominated the industry during a long period of time, such as Panama, TWA,
Sabena or Swissair declared bankruptcy and ultimately ceased operation, others like Delta, Northwest,
United and Continental survived bankruptcy but merged post-bankruptcy.
Low cost airlines had appeared as major players in the market, they began to make their mark
with lower prices and new routes, recording a high growth in North America, Europe and Asia,
however, the established airlines maintained control over their regional hubs. New entrant carriers had
only limited access to landing slots at major airports and the importance of secondary airports started
to grow.
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The most significant transformation in the airline industry after the deregulation remains the
airline alliances. It was estimated that in 2010, more than 95% of all airline passengers had boarded a
flight that was operated as part of an alliance. Airline alliances are known as the innovative efforts
which helps in providing suitable assistance to its customers and also tried to improve the level of
customer satisfaction.
The large number of members of global alliances can increase their negotiating power, when
dealing with suppliers, Iatrou and Oretti (2007) mention fuel, spare parts, maintenance, catering,
airports, charges or cabin crew training as potential sources of cost reduction they can also reduce the
cost of labor by sharing the sales office and bases, members can use cheap labor force (pilots, flight
attendants) of its allies from the other nation without reducing the service quality and the same time
reducing the cost (Iatrou 2004).
After African countries became independent, national governments established their own
airlines. Many newly independent countries desired to have their own flag carriers to showcase their
independence, and those countries wanted large jets like DC-10s and 747s even if the air demand did
not warrant those jets.
Some airlines, like Air Afrique, were jointly sponsored by multiple governments. Some joint
carriers, such as Central African Airways, East African Airways, and West African Airways, were
established when the United Kingdom colonized parts of Africa.
The knowledge of aircraft, the airline industry, and financial capital, originating from the
Europeans, was used to establish the new African carriers. Aircrafts in Africa tend to be older. In
2010, 4.3% of all aircraft in the world fly within Africa. Of older aircraft, 12% fly within Africa.
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