Survival strategy: stay lean and focus on the business customer
British Airways Matthew Lynn says Willie Walsh faces sky-high fuel costs and green taxes as well as aggressive competitors and inadequate airports. But the wily Irishman could still emerge as BA’s best leader yet
Willie Walsh could be forgiven for feeling quietly satisfied with himself. In early May, the jocular Irishman, who was headhunted to run British Airways from the far smaller Aer Lingus, unveiled a doubling of profits. It was a vindication of his strategy. After taking charge of BA in late 2005, Walsh immediately embarked on a round of cost cutting aimed at seeing off the challenge of the low-cost carriers and preparing the airline for an escalation in the oil price.
By this year, it looked to be paying off. In May, BA announced record profits of £680 million. The airline had its widest-ever profit margin, a juicy 10 per cent, and was able to pay its shareholders their first dividend since the 9/11 terror attacks on New York. On the day the results were announced, the shares rose more than 7 per cent. For a man who faced calls from investors to quit following the fiasco of the opening of the new Terminal 5 at Heathrow, it was no doubt a moment to be proud of.
In many ways, Walsh could be shaping up to be the most formidable BA leader since the duo of Lord King and Colin, later Lord, Marshall, led the airline during the turbulent 1980s. He has more flavour to him than the rather bland if efficient Australian Rod Eddington. And he is a big improvement on the catastrophic Bob Ayling.
And yet, for all its success in the past year, BA now faces challenges as testing as any in its history. The airline has to contend with soaring fuel prices that are plunging its entire industry into gloom. It has to steer its way through the climate change debate. Its key London airports are run by an operator, BAA, which is widely viewed as both greedy and inept. ‘Open Skies’ agreements are bringing fresh competitors to its most profitable routes, and its less profitable ones are being stolen by low-cost rivals.
‘It is a horrible time to be an airline,’ said Tim Coombs, joint managing director of the London-based consultancy Aviation Economics. ‘But BA is protected to some degree by having its main base in London, which is one of the best hubs in the world.’
Ever since it was created through the 1972 merger of the British Overseas Airways Corporation and British European Airways, BA has been one of the jewels of the British economy. Privatised in 1987, its transformation from lumbering, state-owned loss-maker to ‘The World’s Favourite Airline’ – one of Saatchi & Saatchi’s best-ever slogans – was emblematic of the UK economic revival during the Thatcher era. It was helped by London’s growth as a financial and business centre – BA’s grip on Heathrow, the world’s busiest airport, was its core asset – and also by the fact that its main European rivals remained in state hands far longer. BA was cutting costs and smartening up its marketing whilst most European carriers were still bloated monopolies.
Until Walsh came along, however, it seemed in danger of losing its way. It launched the ill-fated ‘Go’ as an attempt to compete with Ryanair, then lost heart. In 1997, to Margaret Thatcher’s publicly expressed disgust, it ditched the union jack tailfins. Those decisions were reversed under Eddington, but when Walsh took over it was clear that more needed to be done. Fresh from turning around the ailing Aer Lingus, Walsh conceived two main objectives: to make BA as lean as any player in the industry; and to entrench its position as a premium, business-orientated airline, competing on service as much as cost. With costs soaring, those look to have been the right strategic choices.
And yet right now BA is flying into a storm which, if not quite perfect, is still going to test Walsh’s piloting skills. Most worrying is the oil price. The soaring cost of fuel is hitting all airlines. Even so, BA isn’t looking too smart. Barclays Capital ranked all the major European carriers according to the extent to which they had hedged themselves against the oil price. Lufthansa and Air France led the list, with cover of 83 per cent and 78 per cent respectively. BA was only at 65 per cent.
That’s a lot better than Ryanair’s 2 per cent (maybe the industry’s other wily Irishman, Ryanair’s buccaneering Michael O’Leary, plans to recoup the difference through his in-flight coffee prices) but it still leaves the airline critically exposed to rising oil prices. The difference it makes is startling. With oil at $85 a barrel, for example, Barclays estimates BA would make a profit of £586 million. At $135 a barrel, that turns into a loss of £200 million. An oil price of $125 is the point, on its calculations, where profit turns to loss. Right now, even $125 looks relatively optimistic. Oil is above $130, and some pundits say it could hit $150 or even $200.
Further out, it’s not just the oil price that is pushing up costs. The European Union is planning to include airlines in its emission trading scheme – in effect making them pay to pollute. Although the airlines can mitigate that by buying newer, cleaner aircraft, it is still going to cost. Then there are the British government’s own green taxes. New taxes on flights are scheduled for November 2009, which Walsh is on the record as saying will add £500 to the cost of a family holiday. Of course, Gordon Brown may well have done a U-turn on the issue long before then, and the extra taxes will be paid by the passengers. But the more expensive flying becomes, the less demand there will be for it. No matter how hard Walsh tries to keep his airline efficient, he can’t repeal the laws of supply and demand.
Next, there is the new ‘Open Skies’ agreement, which is opening up airports that were previously the fiefdoms of just one or two airlines. ‘While BA’s entrenchment at the busy London gateway is currently the source of its largest headache, it is also its biggest asset,’ argues CreditSights airlines analyst Brian Studioso. True enough. Heathrow remains one of the world’s key airports. BA has spent a fortune on moving all its operations to the shiny new Terminal 5, and while the opening weekend was one of the great corporate disasters of recent years, the new operation is now working smoothly.
Ambitious though it may have been, at least T5 gets BA into a smart new building: the rest of Heathrow looks more and more Third World, not exactly a place a business-orientated airline wants to process its passengers. ‘Long-term, T5 is going to be an asset for them,’ says Coombs.
BA is trying to turn liberalisation to its advantage. It is launching a new subsidiary cheekily called Open Skies, established at a cost of £17 million. Initially, it will fly from Paris to New York using a model very similar to business-class only airlines such as Silverjet – which, in a clear sign of how tough the market has become, stopped flying in May; a rescue deal has since fallen through.
Open Skies will use Boeing 757, with 24 business-class seats converting to flatbeds, plus 28 premium economy-class seats and 30 basic economy. The plan is to extend it to other European cities as well: Frankfurt, Milan and Brussels could be next on the list. In reality, of course, £17 million isn’t a huge gamble for a company that made more than £600 million last year. Still, it shows the airline is willing to hit back at competitors that are using liberalisation to grab market share.
Longer-term, BA faces even more significant challenges. The climate change lobby has effectively demonised the entire airline industry. Walsh made one ill-judged speech in which he argued that ‘the notion that flying is a selfish, anti-social activity that single-handedly threatens planetary catastrophe bears no relation to the evidence’. Richard Branson, by contrast, a far cannier reader of public moods, said a couple of years ago that all the profits from his airline would go to fighting climate change. Flying isn’t yet socially unacceptable the way that smoking is. But if it goes that way, BA needs to find a way to counter the impact.
‘Competition is heating up, and so is the pressure to consolidate,’ argues Brian Studioso. In Europe, Air France has merged with KLM. Lufthansa took control of Swiss – and has been reported to be in merger talks with both Iberia and Virgin Atlantic. BA has flirted with Iberia over the years – it owns a 10 per cent stake in the Spanish national carrier – but has always stopped short of a full takeover.
There is a more pressing deal to worry about, however. BAA, now owned by the Spanish construction company Ferrovial, faces a Competition Commission enquiry that could see it force the sale of either Gatwick or Heathrow. Maybe BA should buy one or the other: they could call it British Airways & Airports. Crazy? Not necessarily. Lufthansa owns a stake in Frankfurt airport, and it’s not hard to see the logic in BA taking control of its most crucial asset. True, BAA cost more than £10 billion when the Spanish bought it, and BA only has a market value of £2.4 billion. It would take some fiendishly clever investment banker to work out the maths. Still, it is hard to believe Ferrovial hasn’t tired of all the stick it’s been taking, and with the Spanish property market turning to rubble, some cash might come in handy. If Walsh could pull off that deal, he might well go down as the BA’s all-time best pilot.
Matthew Lynn is a columnist for Bloomberg. His new novel Death Force will be published in January