jal‘s choice between skyteam and oneworld

1 Torsten Arnold – JAL‘s choice between skyteam and oneworld

Strategy Case Study: JAL‘s choice between skyteam and oneworld

Tuebingen, 2010/12/21

University of Tuebingen

A case study in the context of the masters seminar

Competitive Strategies

Winter semester 2010/2011

Prof. Dr. Wilhelm Rall

Torsten Arnold


Purpose and Organization of the Research


Questions to be answered

1. What is the value to each of the competing

alliances skyteam and oneworld having JAL on

board

2. What difference in net transfer would make JAL

indifferent between belonging to either alliance?


Outline

1. Understanding the context

1.1 Why alliances

1.2 Economics of Airline Industry

1.3 Modelling Competing Strategic Alliances

1.4 JAL‘s restructuring plans

1.5 JAL‘s alliance decision

2. Airline valuation: value for alliances having JAL on board

3. Alliance valuation: value for JAL beloning to either alliance



1.1 Why alliances?


Why alliances… …instead of fusions?

• Because of economies of scope, scale and their specific network structure leading airlines cooperate in alliances

• In joint ventures (if approved by authorities) they can optimize as a single business unit and share their revenues

• In this setting intense price wars make no sense for the alliance partners

• Customer side: improve product quality and customer service

• Aviation is a strategic

industry national

interests and legal

restrictions are

correspondingly high

• One of the most

restrictive and regulated

industries

• Example: maximum limit

on foreign ownership for

Japanese Airlines is 1/3.


Alliances: solution of basic carrier problems

• Quite simply, empty seats translate into lost profits

• Emergence of Budget Carriers One of the major faults that big airlines were faced with was that of overcapacity

• During the late 90s there was a rather large boom in the procurement of new aircraft.

• Strong demand pushed this trend to extreme limits. It reached a point where there was just too many aircrafts out there with too few passengers to fulfill maximum capacity.

• A most critical time came after 9/11 when consumers dramatically limited their travel habits, which in turn adversely affected the entire aviation industry.


• „The pressure of global competition has brought

us together“BA-Chef Bob Ayling

• External growth (M&A) nearly impossible

• Airline alliances emerged to one of the most

important competitive factors / advantages

Finding the right strategic alliance partners is crucial

Alliances: a managerial standpoint


Alliances: Decision for anti trust immunity approval

by U.S. Department of Transportation

• To assess the competitive effects of a given

alliance, competition authorities look at

• the structure,

• scope,

• and overlap

created by each transaction

• and the likely competitive effects


Scope of Alliance cooperation

+ complexity

+ resources

+ duration

Revenue, cost & benefit

Sharing joint ventures

Direct coordination (incl. prices, routes,

Scheduling, facilities, etc.)

Code sharing

FFP / Lounge Access

Interlining

HIGH

LOW

Merger-like integration

Expanded cooperation to

Develop joint network

Limited cooperation on

specific routes

Figure 1: Spectrum of Alliance Cooperation [Adapted from: Transatlantic Airline Alliances: Competitive issues and regulatory

approaches, A report by the European Commission and the United States Department of Transportation, 16 November 2010]


Benefits and Risks of an Alliance

Figure 2: Benefits and risks of an alliance [Adapted from: Kleymann B., Seristö H. 2001. Levels of airline alliance membership: balancing

risks and benefits, Journal of Air Transport Management , Vol.7, Issue 5, p.308].

Lost flexibility

and sovereignty

Foregone

opportunities

Tighter Integration

Bond

RISKS

Alliance – specific

investments

Economies and

enhanced value

Pledge

Trust

BENEFITS

dete

rren

ce


Degree of overlapping of JAL with either alliance

Network Overlappings

(International Routes)

Cost reduction effects

(through dropping routes)

High degree of

overlapping

low overlapping /

better complementarity

Figure 3: Degree of overlapping of JAL with either alliance. Own illustration



1.2 Economics of Airline Industry


Economics of Airline Industry: Industry Dynamics (1/2)

Pricing

Levels

(Yields)

Profitability

level

Orders

Deliveries

Capacity

adjustments

Supply/Demand

Balance

(Load factor)

Demand

1 year

delay

2 year

delay

Figure 4: Economics if Airline Industry: Industry Dynamics [Adapted from: Philippe d’ARVISENET, Chief Economist, World airline industry:

overcapacities in question. Economic Research Department BNP Paribas, McKinsey & Co, 2004].


Economics of Airline Industry: In a nutshell (2/2)

• Airline industry is cyclical

• Airlines are not only particularly sensitive to external shocks but also to the economic growth.

• During cycle troughs, passenger traffic collapses, load factors display modest performances leading to the mothballing of numerous aircraft and to major declines in airlines’ profitability

• High risk if load factors are too low: high aircraft order cancellation fees limit the possibilities of cancelling the delivery of aircraft ordered in previous years. At best, deliveries are postponed and pay for aircraft at a time when air transportation demand is low

Alliances can reduce correlation effect through world wide diversification „alliances as world market portfolios“: decoupling effect



1.3 Modelling Competing Strategic Alliances


Alliance Modelling: A brief overview

• Park (1997) Transportation Research

• Park, Zhang (1998) Transportation Research

• Brueckner, J.K. (2001) International Journal of Industrial Organization

• Brueckner, J.K. (2002) Journal of Air Transport Management

• Most fundamental potential benefits from consolidation or cooperation

arises from economies of scale, or lower per-unit costs from an

increased level of output

• Alliance tends to lead to higher traffic

• Cooperative pricing can internalize part of the double-marginalization

externality („vertical integration“: Tirole, 1988)

• Welfare tends to increases in complementary networks; parallel

alliances/networks tend to decrease welfare


• Rivalry between strategic alliances where each alliance member maximizes its own profit and some share of ist partner‘s profit

• Two firms link up their complementary products in the context of competing strategic alliances Within-alliance complementarities

• Cross-alliance substitutabilities („peanut butter / jelly alliance pairs“)

• Two-stage alliance game: • stage 1: level of cooperation, α or β chosen

• stage 2: output level decision

Modelling Strategic Alliances (1/3)

Figure 5: Basic Model Structure [Source: Zhang, A., Zhang Y., (2006). Rivalry between strategic alliances. International

Journal of Industrial Organization 24, 287-301]

(eq. 1)

(eq. 2)

(eq. 3)

(eq. 4)



• Greater output levels possible and also alliance creation can

deter entry for rivals

• Strengthening of one of the alliances increases the output

of both member firms‘ products and decreases that of their

rival firms

• Complementary alliance

• improves the alliance‘s own profit, given the alliance

structure of the rival firms

• It defends the allied firms when the rival firms intnsify their

cooperation

„agressive“


• Rivalry between multiple alliances, may, owing to the

strategic effect, result in a higher degree of inner-alliance

cooperation than would be in the absence of rivalry

• But Prisoners dilemma possible

• cooperation on a given route gives the parties market

power that they can exercise

• sustainably by raising prices, lowering capacity and/or

degrading quality of service




1.4 JAL‘s restructuring plans


Corporate structure of the JAL-Group

JAL Group

International

Passengers

Domestic

Passengers

Cargo

Airline-related

business

Hotel and

resort

business

Credit card

and leasing

business

Commercial,

distribution

and other

business

Travel Service

Air transportation business Other business subsidies

Figure 6: Corporate structure of JAL Group 2010. Own illustration. Data Source: JAL Website

• JAL International

• JAL Domestic

• Japan Asia Airways Co., Ltd.

• Japan Trans Ocean Air Co., Ltd.

• JALways Co., Ltd.

• JAL Express Co., Ltd.

• Japan Air Commuter Co., Ltd.

• J Air Co., Ltd.

• Harlequin Air Co., Ltd.

• Hokkaido Air System Co., Ltd.


Figure 7: International and domestic passenger traffic and income of JAL Group, including: JAL,JAPAN TRANSOCEAN AIR, JAL

EXPRESS, J-AIR, Japan Air Commuter, Hokkaido Air System, & RYUKYU. Own illustration. Data Source: JAL Website

0

100.000

200.000

300.000

400.000

500.000

600.000

700.000

800.000

0

5.000.000

10.000.000

15.000.000

20.000.000

25.000.000

30.000.000

35.000.000

40.000.000

45.000.000

50.000.000

FY2002 FY2003 FY2004 FY2005 FY2006 FY2007 FY2008 FY2009

Domestic passengers International passengers

Domestic passenger income (Mio. of Yen) International passenger income (Mio. of Yen)

Domestic vs. International passenger income of JAL


Reasons for the insolvency of JAL

• High Fixed and Variable Costs (very expensive pieces of equipment, large labor forces, high fuel costs) Cost Factor

• Decreasing overall demand (9/11, Iraq War, SARS)

• Decreasing number of business travelers (global recession in fall 2008)

• Decreasing tourism demand (high fuel surcharge)

Decreasing

Demand

• JAL was moving too slow on the opportunities in the low cost carrier (LCC) business

• Traffic was still dominated by business travel and freight both of which were more sensitive to global fluctuations

Strategic Failures

Figure 8: Main reasons for the insolvency of JAL. Own illustration


The restructuring plan of JAL

“Create a solid business model that can withstand the

fluctuations in economic conditions and generating

profits without overly relying on future traffic demand”

Main Restructuring Target:

Cost

Reduction

• Lay-off around 16.000 employees by 01.03.2011 (1/3 of the staff)

• Discharge of Boing 747-400 and Airbus 300-600

• Adjustment of the corporate pension fund

• Suspenion of 28 international and 50 domestic routes, closure of 11 overseas bases and 8

offices

• Liquidating and selling subsidiaries including hotel businesses (sell 79.6% stake in JAL Hotels)

Financial

Support

• New credit lines of about € 4,6 billion

• Enterprise Turnaround Initiative Corp (Etic) will invest about € 2,3 billion in JAL

• The creditors (e.g. Mizuho Corporate Bank, Bank of Tokyo-Mitsubishi UFJ) will dsclaim about €

5.6 billion of debts

• The JAL stock will be delisted from the market

• Example should be General Motors in the U.S.

• Enterprise Turnaround Intiative Corp. (Etic), will take responsibility of the restructuring

• From 1.02.2010 Kazuo Inamori, the founder of Kyocera will be the new CEO

• On 1st of December JAL received permission from Tokyo's District Court to go ahead with its

rehabilitation plan.

Important

Measures


However the restructuring plan also effects the

passenger figures -> Load Factor is crucial

69

64,6

69,3 69,4

71,1 71,8

65,6

69,4

60

62

64

66

68

70

72

74

0

2.000.000

4.000.000

6.000.000

8.000.000

10.000.000

12.000.000

14.000.000

16.000.000


International passengers International Load Factor

65,3

63,9 63,7 64 64 63,4 63,7

59,2

56

58

60

62

64

66

0

10.000.000

20.000.000

30.000.000

40.000.000

50.000.000


Domestic passengers Domestic Load Factor

Decreasing load

factor only on

domestic routes!

Inte

rnati

on

al

Do

mesti

c

Figure 9: Passengers and load factors: Domestic and International, Own illustration and adapted from given material McKinsey & Co.



1.5 JAL‘s alliance decision


Two equal forces?

Oneworld Skyteam

Members: 14 *

* including Kingfisher TBA, Airberlin 2012

Members: 13

Destinations: 701

Countries: 136

Destinations: 898

Countries: 169

Daily Departures: 8,244 Daily Departures: 12,597

Annual Passengers: 291.1 m Annual Passengers: 385 m

Frequent Flyer members: 100 m Frequent Flyer members: 148 m

Lounges: 506 Lounges: 420+

Fleet (operated): 2203 Fleet (operated): 2225+

Formation: 1999 Formation: 2000

Players directly interested in JAL:

American Airlines, British Airways, Cathay Pacific

Players directly interested in JAL:

Delta

Transatlantic Passengers: 5.36 m Transatlantic Passengers: 6.66 m

Transatlantic Market Share: 22.7% Transatlantic Market Share: 28.3%


JAL‘s outline for decisions making: Should I

stay or should I go? Stay with AA (oneworld):

• Familiar partner, knowledge of each others’ business ways

• According to JAL management, to remain with the same alliance will be more cost-effective

• Highest quality partners at oneworld to pass on valued customers

• Less confusing for JAL customers

• Complementary – rather then overlapping – networks (in DELTA: competition with

Delta/Northwest, Korean and China Southern)

• Delta/Northwest operation at Tokyo Narita would most likely not fit alongside JAL‘s operations

• Regulatory risk in case of change in alliance strategy when moving to Skyteam

• Most likely the only opportunity to gain ATI between USA and Japan with a US partner

Switch to DELTA (skyteam):

• Delta has a more robust trans-Pacific flight network

• Delta has a stronger Asian network than American Airlines

• Delta offers access to their large global network of passengers and routes. Delta is the world's

biggest airline

• Larger direct equity investment

• Easier for JAL to implement the restructuring plan (suspension of routes)


The chaotic chronicle of events in bidding for JAL

End of 2009

January 15th

• Open skies agreement USA - Japan

• Information globally echoed by press agencies: JAL had reached

an agreement over a tie-up with Delta Air Lines. Delta Air Lines

would inject 1 Bn USD to JAL to help it switch alliances

• JAL filed in the meantime for bankruptcy protection and entered into

a restructuring process with the support of the Japanese

government

To counterstate this, AA and oneworld announced to raise their

offer to 1.4 Bn USD

January 18th

• Delta and KLM reached an agreement and Air France KLM would

contribute to the financial package

End of January • New president at JAL

February 8th • JAL Decision to stay with oneworld


2. Airline valuation

What is the value to each of the

competing alliances skyteam and

oneworld having JAL on board ?


Asian flight market: Facts and figures

• Growing markets • Overall passenger volume between North America and the

Asia/Pacific region is expected to rise 3.8 percent in 2010 and 5.6 percent in 2011, according to a survey of airlines conducted by IATA

• Between Europe and the Asia/Pacific region, it is expected to rise 4.4 percent in 2010 and 6.1 percent in 2011

• High margin premium travellers • Travel from North America to the Mid-Pacific region, which

includes Japan and South Korea, represented 5.8 percent of total premium international air traffic in November 2009, but 12 percent of all the premium revenue, according to the International Air Transport Association (IATA) data

• "It's really where the money is these days," Charles River Associates aviation consultant Mark Kiefer said of Asia.


Valuation of JAL – Three scenario world (1/2)

Basic assumptions: • JAL passenger figures from FY2008 including restructuring plan

• Domestic flights are taken into account with 1/3 of the volume

• Regional dynamic growth rates over five years

• Varying ticket costs (low economy class – high business class)

• Discount factor (risk premium)

• Net income margin 1% of revenues

• Revenue stream of JAL respectively the profit is the benefit to

OneWorld / SkyTeam

Criticism: • Very high leverage on the ticket price variable, in addition highly

imprecise figure

• Net income margin of 1% unrealistic, since 1995 only 6 times

positive net income by JAL

• Growth rates in reality highly unpredictable

• NPV tool can be criticized (e.g. perfectly competitive capital

market, credit/debit interest equal, subjective target rate)


Estimated Value of JAL for the alliances

Valuation of JAL – Three scenario world (2/2)

Low level

scenario Medium level

scenario

High level

Scenario

• Low economy class ticket

prices

• Moderate growth rates,

especially in the Asia

region

• Average ticket prices

• Medium growth rates

• High level business class

ticket prices

• High dynamic growth rates

$ 1.440 Mn $ 760 Mn $ 420 Mn

~ $ 871.460.682 $ 417.782.429 $ 1.440.884.780


Ex-ante conclusion for players of both alliances

• An open-skies treaty and ATI for (Star and) Oneworld will give

Delta more competition than now

• Delta is not a huge loser

• They still have Tokyo and an immunized alliance with Korean

Airlines

• They remain a most formidable competitor across the North Pacific

(AA) (DAL)

Alliance with positive (strategic+)

clear negative (strategic - -)

mild negative (more competition -)

modest positive (strategic ++, high costs -)

Figure 10: Ex-ante conclusion for players of both alliances. Own illustration , adapted from „ S&P's Ratings Services” analysis (*)

No alliance with


3. Alliance valuation

What difference in net transfer would

make JAL indifferent between belonging

to either alliance?


General advantages for potential JAL investor:

Reasons for Delta and AA to opt for JAL

• JAL's Asian routes and the premium passengers that come with them

• Access to the Japanese market, especially with regards to business travellers and access to JAL's network to the rest of Asia (cornerstone hubs) • Access to higher fares for seats to Asia because international business

travelers tend to spend more than leisure fliers

• Business travelers fly more and often at the last minute, which means paying higher walk-up fares

• More power to help shape overseas customer options and ticket prices

• Potential to fly its own aircraft and passengers on JAL's routes

• Bigger revenue stream: Potential additional revenue of 340 Mn EUR*

• Synergy effects yield significant cost advantages • Joint usage of lounges and transfer centers

• Comparison: Est. 17 Bn USD in cost savings achieved at Star Alliance (2008)

qu

alita

tive

q

uan

tita

tive

*Source:Handelsblatt, 2010: „ Japan Airlines: Luftfahrt-Bündnisse reißen sich um die angeschlagene Braut”


ATI application: Scenarios and market shares

30% 35%

35%

US-Japan market share (in %): Scenario JAL at oneworld

skyteam

oneworld

other

54%

6%

40%

US-Japan market share (in %): Scenario JAL at skyteam

• JAL/oneworld continuation is most likely procompetitive

• JAL/SkyTeam switch could be anti-competitive

• US regulators (DTO) could block closer ties between Delta and JAL because the two would dominate US-Japan traffic

Figure 11: US-Japan market share in % depending on JAL at Oneworld or JAL at SkyTeam. Own illustration


1100

500

300

200

500

300

810

0

200

400

600

800

1000

1200

1400

1600

1800

2000

Value of alliances for JAL:

A net transfer of ~ 200 - 400 Mn USD would make JAL indifferent

Direct Capital

Investment (2)

Present Value of

potential Trans-Pacific

ATI for JAL (1)

- 200

1,400

Enhanced offer

by oneworld

Figure 12: Total value propositions at stake as of February 2010. Own illustration (1) Based on 100 Mn USD incremental revenue over four years at present value; Discount factor = 10%, Expected annual growth = 2%

(2) Collateralized debt: Near-term cash, adds to debt burden of JAL

(3) Direct capital investmemt from AA/TPG (oneworld) and Delta/France KLM (skyteam)

(4) Switiching costs due to change of alliance membership (

(5) Due to cost reductions and network overlapping (ETIC estimate = 189 Mn USD p.a.; over first 4 years:, Discount factor = 10%, Expected annual growth = 2%)

Present Value of

additional

annual benefits

compared to

oneworld alliance (5)

1,000

Total one-time

switching costs (4)

Alliance

revenue

guarantee

Asset-backed

funding (3)


Thank you for your attention!


List of figures


List of figures

Figure 1: Spectrum of Alliance Cooperation [Adapted from: Transatlantic Airline Alliances: Competitive issues and regulatory approaches, A report by the European Commission and the United States Department of Transportation, 16 November 2010]

Figure 2: Benefits and risks of an alliance [Adapted from: Kleymann B., Seristö H. 2001. Levels of airline alliance membership: balancing risks and benefits, Journal of Air Transport Management , Vol.7, Issue 5, p.308].

Figure 3: Degree of overlapping of JAL with either alliance. Own illustration

Figure 4: Economics if Airline Industry: Industry Dynamics [Adapted from: Philippe d’ARVISENET, Chief Economist, World airline industry: overcapacities in question. Economic Research Department BNP Paribas, McKinsey & Co, 2004].

Figure 5: Basic Model Structure [Source: Zhang, A., Zhang Y., (2006). Rivalry between strategic alliances. International Journal of Industrial Organization 24, 287-301]

Figure 6: Corporate structure of JAL Group 2010. Own illustration. Data Source: JAL Website

Figure 7: International and domestic passenger traffic and income of JAL Group, including: JAL,JAPAN TRANSOCEAN AIR, JAL EXPRESS, J-AIR, Japan Air Commuter, Hokkaido Air System, & RYUKYU. Own illustration. Data Source: JAL Website

Figure 8: Main reasons for the insolvency of JAL. Own illustration

Figure 9: Passengers and load factors: Domestic and International, Own illustration and adapted from given material McKinsey & Co.

Figure 10: Ex-ante conclusion for players of both alliances. Own illustration , adapted from „ S&P's Ratings Services” analysis (*)

Figure 11: US-Japan market share in % depending on JAL at Oneworld or JAL at SkyTeam. Own illustration

Figure 12: Total value propositions at stake as of February 2010. Own illustration


Appendix: Quantitative Analysis


Question 1 – Low level scenario (1/3)


Question 1 – Medium level scenario (1/3)


Question 1 – High level scenario (1/3)


Backup


Scope of Alliance cooperation

+ complexity

+ resources

+ duration

Revenue, cost & benefit

Sharing joint ventures

Direct coordination (incl. prices, routes,

Scheduling, facilities, etc.)

Code sharing

FFP / Lounge Access

Interlining

HIGH

LOW

Merger-like integration

Expanded cooperation to

Develop joint network

Limited cooperation on

specific routes

Figure X: Spectrum of Alliance Cooperation [Adapted from: Transatlantic Airline Alliances: Competitive issues and regulatory

approaches, A report by the European Commission and the United States Department of Transportation, 16 November 2010]

jal‘s choice between skyteam and oneworld

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