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

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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.

                                                                                      Building a Strong Foundation
      In some cases, immunized JVs occur between large, global
      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
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                                                                                        Figure 1
                                                                           Understanding Airline Collaboration

                                                                      Equity investment can occur throughout the
                                                                    process, although vested interest typically yields
                                                                              increased overall cooperation

                Fully independent
                                                        Interline                     Codeshare                    Joint Venture                    Merger
                (no collaboration)
                                                                                                                                             (full collaboration)

                                                                                   Shared frequent flyer program, lounge access and
               Airline has all the                                                  coordinated schedules may be enabled early on
            decision making power                   Commonly achieved             through an alliance, or be achieved later on in con-          Allows for full
              and does not share                   through alliances and        junction with a joint venture; however, fare alignment       integration between
            information with other                low-level partnerships         and network optimization typically follows antitrust              carriers.
                     airlines                                                   immunity (ATI) and is likely to be maximized following
                                                                                              a joint venture agreement.

         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
                                                                                               		 Virgin Atlantic leisure traffic destined for the Caribbean.
         Determining the Right Structure
         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:
                                                                                               		Market Example: When Air France, KLM and Delta formed
                                                                                               		 a transatlantic JV, it included specific carveout provisions
             • Which regions or routes will the partnership
                                                                                               		 to capture and jointly account for connecting traffic from
                  agreement cover? Will there be full metal neutrality
                                                                                               		 Los Angeles to Papeete and from Amsterdam to India.
         		 for all of these routes? How will “behind” and “beyond”
                                                                                               		 As a result, Delta and KLM split operations to India, with
         		 traffic be handled – that is, the connecting flights to and
                                                                                               		 Delta exclusively operating to Mumbai and KLM exclusive-
         		 from the shared gateways?
                                                                                               		 ly operating to New Delhi. In contrast, the A++ JV
                                                                                               		 between Air Canada, Lufthansa and United fully covers

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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?

                                                                                                  • Which sources of revenue will be subject to the
       Deciding on a Partnership Mechanism
                                                                                                    agreement (e.g., ancillaries, loyalty revenue,

       The most tenuous and time consuming portion of JV forma-                                     cargo, etc.)?

       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
       examining the following questions:                                                         40%
                                                                                                                                                                       4%
                                                                                                                                                                      CAGR
                                                                                                  35%
          • Will the joint enterprise operate as a revenue-
                                                                            Percentage of Seats

                                                                                                                                                     30.2%
                                                                                                  30%
            sharing or profit-sharing venture?
                                                                                                  25%

       		Market Example: While the vast majority of JVs are                                                                           29%
                                                                                                  20%                                 CAGR
       		 structured as revenue-sharing ventures, Delta has execut-
       		 ed profit-sharing agreements for both of its transatlantic                              15%

       		 joint ventures. While challenging to negotiate and imple-                               10%                8.8%
       		 ment, Delta decided that profit sharing ultimately
                                                                                                  5%
       		 ensured an optimally aligned incentive structure.
                                                                                                  0%
                                                                                                                     2003                            2013                            2023F
          • How will standalone (i.e., baseline) profitability of
            each party be determined? How many years prior to                                                       Transatlantic                  Transamerica                    Other

       		 the agreement will be considered? Will adjustments be                                                     Transpacific                   E.U. to Asia

       		 permitted to account for irregularities?
                                                                                                        Note: *Includes routes at least 2,500 nm in length with at least 52 flights p.a.
                                                                                                        Source: Diio Mi, L.E.K. analysis

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                                                                                                  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                                               Ensuring Good Governance
              allocated to the JV? What is the mechanism to deal
         		 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%                                              • Who owns pooled resources such as takeoff and
         		 (AF/KL) – a strong indication that a proportionality cause                                              landing slots at major airports and how are those
         		 has been enforced as joint capacity was rationalized.                                                   resources managed by the JV?

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          • Under what conditions, if any, will be the partner-                               Looking Toward the Future
              ship agreement be void (e.g., insolvency by one
              party)?                                                                         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.

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