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(originally published by Booz & Company)


The Airlines’ Global Dilemma

Traditional carriers once knew their way around. Now the world has become a confusing place.

Airlines were global before much of the business world knew global existed. As early as 1919, Chalk’s Ocean Airways was carrying passengers between Florida and the Bahamas in pontoon-bottomed seaplanes. That same year, regular flights between London and Paris began. By the mid-1930s, Pan Am was routinely flying to China, the Philippines, and Japan. International travel quickly became the most romantic, highest-margin segment of the airline industry, and it remains so today.

Given their rich international experience, you might think the major Western airlines — the so-called legacy carriers, like Delta Air Lines, British Airways, and Air France, among many others — would be well positioned to take advantage of globalization, now that other industries have caught up to them in seeing the profitability possibilities of worldwide commerce. But that’s not the case; in fact, unlike for virtually every other industry, for the traditional airlines, globalization is not an opportunity, but their gravest threat.

For example, as auto, chemical, and pharmaceutical companies have demonstrated, this is a perfect time for international consolidation to better scale resources around the world. For large carriers, such mergers and partnerships could go a long way toward significantly cutting costs by reducing competition, using the workforce and planes more efficiently, and reconfiguring route networks to make them less redundant. But these global transactions are not in the cards. Although American Airlines and British Airways, for example, have tried to merge in the past, they called it off because the United States, like most other countries, puts strict limits on foreign ownership; in the U.S., no more than 25 percent of voting shares can be owned by non-American equity holders. (Europe remains the only continent where laws favor cross-border airline mergers, but that’s primarily because Europe is akin to a single market with numerous small countries.) Because of these restrictions, international consolidation is effectively precluded for most large carriers, so they have to make do with local mergers, such as the recent Delta–Northwest and United–Continental deals in the United States. Those kind of linkups will help drive down costs in mostly saturated markets but do little to position the airlines to take advantage of potential growth in rising markets like India and China.

Ownership restrictions are just one set of leftover nationalist regulations that traditional carriers are forced to grapple with. Equally disconcerting and difficult to navigate are the sometimes inconsistent — or at least illogical — policies that governments impose in many countries. Take the route-by-route joint venture, a way that many airlines are using to get around rules against consolidation and M&A. Under this approach, airlines form service agreements with one another on specific routes and share the costs and profits equally. The joint venture partners cooperate on departure times, types of aircraft to use, distribution, and marketing. In so doing, they gain access to customers in regions where they are weak.

This concept was pioneered by Australia’s Qantas Airways and British Airways in 1995 for the “kangaroo route” that links Australia and Great Britain over the eastern hemisphere. Antitrust enforcers allowed a five-year exemption for the deal in 1995 and have continuously renewed it since. However, approval of these partnerships is difficult to obtain in some countries. In September, the U.S. Department of Transportation denied a proposal by Delta and Virgin Blue to set up a route-by-route venture between Australia and the United States. Regulators felt that the deal unfairly favored Delta over rival United and balked at granting slots and landing rights to Virgin Blue on the West Coast. Thwarted by the Department of Transportation, Virgin struck a partnership deal with Abu Dhabi’s Etihad Airways in which travelers can take Virgin flights from Australia to Abu Dhabi and board an Etihad plane to New York and Chicago.

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