A Different Flight Path

With a successful financial reorganization behind it, Air Canada is turning the legacy airline model on its head.

By Perry Flint
Montreal
Air Transport World, April 2006, p.24

If this were a typical tale of a North American airline financial restructuring, Air Canada probably would be readying its employees and lenders for another trip through the corporate steam room to sweat out some more savings in addition to the C$2 billion shed during its year-and-a-half reorganization. Instead, 18 months after emerging from Canada's Companies' Creditors Arrangement Act on Sept. 30, 2004, it is writing a new script and going where no legacy carrier has gone before.

AC has adopted a business model built upon a simple and transparent fare structure in which the cheapest fare is available until the cabin door closes but passengers are given incentives to buy up to the next level. Last June it carried out the world's first monetization of a frequent-flier loyalty program, selling 15% of Aeroplan LP and raising almost C$300 million for parent company ACE Aviation Holdings, which retains an 85% stake valued at some C$2.2 billion.

It followed this in January with the partial spinoff of Jazz, its Regional subsidiary that operated nearly 700 daily departures to 73 domestic and US destinations with a fleet of 121 mostly regional jet aircraft at year end. Just below 20% of Jazz was sold, raising gross proceeds of C$235 million. AC's remaining holding is worth nearly C$1 billion. Next on the list: Air Canada Technical Services, the airline's respected MRO organization, later this year or in early 2007.

But ACE Aviation Chairman and CEO Robert Milton isn't just selling, he's buying as well. Taking a leaf from the playbook of Hollis Harris, the man who brought him to Air Canada in the early 1990s and who made a fortune for AC by bailing out Continental Airlines, Milton has bet on the reorganized US Airways with a ground-floor investment of C$87 million for a 7% holding that was valued at C$193 million in late February. The deal clincher: ACTS gets right of first refusal to any maintenance business US Airways sends outside. Then there's the financial performance to consider. In 2005, its first full calendar year outside CCAA, ACE reported net income of C$258 millionthe best result for any North American legacy airlinewhile returning nearly C$55 million to employees in the form of profit-sharing checks. A 10.5% rise in annual sales to C$9.83 billion yielded a fourfold jump in operating profit to C$452 million despite a C$592 million surge in fuel expense. Nonfuel unit costs have dropped in nine of the past 10 quarters while productivity, measured in ASMs per employee, has risen in all of them.

On the traffic front, February 2006 represented the 23rd consecutive month of record load factors. More importantly, WestJet's seemingly inexorable advance through Air Canada's domestic network has been halted, with AC running a load factor premium for more than a year and a half. In Milton's words, AC "has the cost structure to compete with low-cost carriers on price while offering services and products which discount carriers simply can't match."

Fleet renewal and growth are also on the agenda. ACE is a major customer for the new families of large regional jets including the Embraer 175 and 190, which are operated by mainline pilots at competitive rates, as well as the CRJ705 flown by Jazz. Next March, the first of up to 36 777s arrives while 14 firm 787s will fill out the fleet from 2010 with another 46 on option. Included in the 777 order are a pair of 777Fs, the first freighters AC has operated on its own account for many a year, although it wet-leases three today.

Finally, to make sure passengers are comfy once they get onboard, it is installing new seats in all its aircraft, including lie-flat seatbeds in its intercontinental Executive Class cabins. And in a first for any network airline, it is putting audio/video on demand at every seat of every aircraft of 70 seats or more in its domestic and international fleets.

All of this makes the 13th-largest carrier in the world by RPKs one of the most progressive. By itself, the mainline carries around 24 million passengers annually and operates some 634 daily flights to 114 destinations in North, Central and South America, Europe and the Asia/Pacific region. In combination with Jazz the figure rises to some 1,200 daily flights across a network of 170 destinations. Throw in Star Alliance codeshares and the total number of destinations leaps to 795 in 139 countries.

Moreover, AC leads each of its market segments, with a 60% ASM share of the domestic market that generates 40% of airline revenue, a 49% grip on the Canada-international market that also generates 40% (the next nearest competitor is British Airways with 7%) and a 40% share of the transborder market that provides the remaining 20% of airline revenue.

Although it is tempting to attribute most or all of Air Canada's revival to the C$2 billion in cost reductions achieved during the CCAA process (see box, p. 28), its success is at least equally owing to the new "customer-centric" revenue model adopted in May 2003 at the peak of the SARS crisis that had precipitated its bankruptcy filing one month earlier. President and CEO Montie Brewer, who joined AC as executive VP-planning from United Airlines in April 2002, says, "Our costs were out of line, but I think a lot of carriers think it's all about costs and has nothing to do with how you approach the marketplace. We thought it was both. We had to get our costs in line and we had to approach the market differently."

He is candid about the problem: "We had a [legacy] pricing model that was very customer unfriendly. It drove a wedge between us and the customer that made it very easy for someone coming in with lower costs [such as WestJet] . . . to easily differentiate themselves and be on the positive side of the customers."

Milton recalls that he and Brewer made the decision to adopt the new pricing structure against the advice of the carrier's revenue managers, who feared the airline would not survive the immediate revenue hit from abandoning "the gouging routine," as he describes the typical legacy fare structure. But with AC's planes flying mostly empty after a World Health Organization warning to avoid Toronto, Milton figured they didn't have much to lose. "I remember looking at Montie and saying 'Okay, Montie, now we do it,' because we had no revenuethere were no passengerseverybody had gone and nobody was coming to Canada."

The product AC rolled out in the domestic market consists of five branded fares, each with its own price points and attributes. All are sold on a one-way basis right up to the time of departure and none require a Saturday-night stay or advance purchase. They are Tangothe deep-discount product targeted at WestJetTango Plus, Latitude, Latitude Plus and Executive (business) Class.

Passengers who buy a Tango fare know upfront that they have purchased a nonrefundable ticket that does not come with advance seat selection, but for an extra C$15 they can reserve their seat. They only earn 50% of applicable Aeroplan miles and no status miles; however, if they want a bit more they can pay C$30 extra and bump up to Tango Plus and receive advance seat selection plus 100% Aeroplan status miles. And so it goes all the way up to the business class product. "We know we have to compete with the LCCs but we also want to offer the value proposition that if you want these extras, we offer them," Executive VP and CCO Sean Menke explains.


Buy Up

"The simplified fare structure has allowed us to differentiate ourselves because we're the only one who offers options in a clear, transparent way," Brewer says. He stresses that AC does not restrict the availability of Tango and Tango Plus simply to force travelers into the other categories: "If we want a better mix of clientele, we have to convince people to buy a higher fare." Milton adds, "It is surprising the extent to which people 'buy to the right' and it is accelerating as corporations latch onto the fact that they'd just as soon buy a slightly higher fare to give their people more flexibility."

The impact of the change is reflected in AC's domestic unit revenue improvement, which began in 2004 and has continued through seven quarters, including an 11.9% year-over-year RASM gain in the 2005 fourth quarter. It also began running a significant monthly domestic load factor premium to WestJet in mid-2004 that Milton largely attributes to the new fare structure. "Once we cut to the $299, no-advance-purchase, no-Saturday-stay, fully transparent, always up against the low-cost carrier, the consumer said, 'Hey, I'm going to fly AC for the overall network, for frequency of service, for experience and for frequent-flier points.' "

Having made a success of it in the domestic market, AC brought the structure to the transborder market in 2004 and took its first step into intercontinental markets in January 2006 on flights to the UK.

The transparent pricing has had another important benefit: Knowing they won't face myriad hidden rules and restrictions, customers are confident in using aircanada.com to buy their seats. In fact, Milton says AC distributes more than 60% of its domestic sales via the Internet. That's the kind of figure one would expect from an LCC, not a full-service global airline.

And AC is not stopping there. Executives speak of going beyond today's transaction-based business model. "We'd like to be in the place where most of our customers buy travel on subscription, where we're basically a travel provider and our customers pay a monthly fee and they have access to our system," Brewer says.

The carrier has rolled out a number of pass products for both business and leisure travel, typically offering a fixed price for a pre-set number of segments. The Rapidair Pass connects the Ottawa-Montreal-Toronto triangle in the East while a similar product is offered for Western Canada linking Edmonton, Calgary and Vancouver. The Flight Pass for Small Business contains 30 flight credits (segments) that up to eight different employees can use over a three-month period. Larger corporations can take advantage of the Corporate Pass, which can be used by up to 300 employees. AC also offers "zonal pricing," based not on individual city-pairs but rather on travel within a particular province or among provinces.

Leisure travelers can purchase Sun Passes for trips back and forth to destinations in Florida. Last-minute travelers might purchase the Weekend Flight Pass available during the winter for quick getaways across Canada. Menke says the passes have been well received and AC continues to develop new products. He declines to say how much revenue comes from pass sales versus traditional tickets but offers, "It's below 10% right now." Passes also provide an opportunity to trim distribution costs further since they can be purchased via the Web, reducing transaction and credit card fees. "Transactions through a GDS are in the C$14-C$18 ballpark while from a Web standpoint you're in lower single digits, so we want to take advantage of the opportunity," he says.

Of course, Air Canada also needs a route network to take people where they want to go and it has been relentless in expanding and restructuring. Jazz is spreading its wings across North America and has become AC's growth vehicle in the domestic market. All of ACE's 6% 2006 capacity increase within Canada will occur there. "Jazz is about a 30% lower cost producer of capacity" than the mainline, Milton says. It is using its CRJ200s and new CRJ705s to connect markets with nonstop service, such as Abbotsford-Toronto, and to open new city-pairs like Vancouver-San Diego.

The mainline's Embraer 170s and 190s, meanwhile, are being deployed largely in Canada-US markets, where capacity will rise 10% this year. Flown by pilots at rates Brewer believes are competitive with JetBlue, the long-legged 190s enable AC to operate routes such as Calgary-Newark and from Toronto to the US West Coast. "They can do a five-hour mission," he observes. "They open up a lot of markets that previously could only be served with aircraft that were a little too large."

Looking at long-haul, AC recently launched Toronto-Tokyo, while last year's agreement with China will permit a threefold rise in capacity, with Toronto-Beijing going daily this year and new daily Toronto-Shanghai service starting in the summer. Latin America is seen as a big opportunity, both for point-to-point markets and for the ability to capture traffic from Asia and Europe that formerly flowed through the USnow an unpalatable choice given new US visa and security requirements. Last fall's US-Canada open skies agreement includes unlimited beyond rights, making the Toronto and Vancouver hubs natural gateways into US cities from Europe and Asia.

Despite AC's recent successful aggressive expansion, Brewer and Milton remain focused on controlling costs, so much so that after losing C$103 million in the seasonally weak December quarter of an otherwise strong year, ACE announced it will lay off 600 salaried and management employees this year. "There is no room for any complacency and we must continue to improve efficiencies throughout our business," Milton said at the time. He worries about external factors over which the carrier has little or no controlterrorism, fuel prices and operating a hub at the highest-cost airport in the world: Toronto Pearson International.

Air Canada must continue to "morph" into a different kind of airline, Brewer believes. "We have to stay focused on what the customers want and continue to design products for them. We need to finish moving ourselves into a different company so we can get our costs out and provide a better product for our customers and a better place for our employees to work." Nevertheless, the view looks a lot better today than it did at the beginning of the journey in the spring of 2003.


Targeting Efficiency

Of the C$2 billion that Air Canada says it cut during its April 1, 2003-Sept. 30, 2004, CCAA reorganization, about C$750 million came from aircraft leases and financial instruments and about C$500 million from suppliers, with the balance from staff, according to ACE Chairman and CEO Robert Milton.

With the exception of the pilots, who took hefty pay cuts rather than work rule changes, most of AC's unions agreed to significant productivity improvements. Milton said the average non-pilot at AC saw a 3% pay cut while pilots agreed to a 20% pay reduction for narrowbody North American flightcrews and widebody long-haul crewmembers had pay reduced by 15%. Executives took pay cuts as well, with Milton's salary reduced 20%.

AC also cut its staff by about 10,000 compared to the beginning of 2003 through voluntary separations and layoffs. When discussing efficiency improvements, Milton likes to cite Air Canada Technical Services. "One of the key areas where it helped us was simplification of categories of mechanics . . . We had 19 classifications of mechanics. Today, anyone qualified to do the work can do it."

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