BUSINESS PROCESS REENGINEERING (BPR)

Introduction

If you have ever waited in line at the grocery store, you can appreciate the need for process improvement. In this case, the "process" is called the check-out process, and the purpose of the process is to pay for and bag your groceries. The process begins with you stepping into line, and ends with you receiving your receipt and leaving the store. You are the customer (you have the money and you have come to buy food), and the store is the supplier.
The process steps are the activities that you and the store personnel do to complete the transaction. In this simple example, we have described a business process. Imagine other business processes: ordering clothes from mail order companies, requesting new telephone service from your telephone company, developing new products, administering the social security process, building a new home, etc.
Business processes are simply a set of activities that transform a set of inputs into a set of outputs (goods or services) for another person or process using people and tools. We all do them, and at one time or another play the role of customer or supplier.
You may see business processes pictured as a set of triangles as shown below. The purpose of this model is to define the supplier and process inputs, your process, and the customer and associated outputs. Also shown is the feedback loop from customers.

So why business process improvement?

Improving business processes is paramount for businesses to stay competitive in today's marketplace. Over the last 10 to 15 years companies have been forced to improve their business processes because we, as customers, are demanding better and better products and services. And if we do not receive what we want from one supplier, we have many others to choose from (hence the competitive issue for businesses). Many companies began business process improvement with a continuous improvement model. This model attempts to understand and measure the current process, and make performance improvements accordingly.
The figure below illustrates the basic steps. You begin by documenting what you do today, establish some way to measure the process based on what your customers want, do the process, measure the results, and then identify improvement opportunities based on the data you collected. You then implement process improvements, and measure the performance of the new process. This loop repeats over and over again, and is called continuous process improvement. You might also hear it called business process improvement, functional process improvement, etc.
This method for improving business processes is effective to obtain gradual, incremental improvement. However, over the last 10 years several factors have accelerated the need to improve business processes. The most obvious is technology. New technologies (like the Internet) are rapidly bringing new capabilities to businesses, thereby raising the competitive bar and the need to improve business processes dramatically.
Another apparent trend is the opening of world markets and increased free trade. Such changes bring more companies into the marketplace, and competing becomes harder and harder. In today's marketplace, major changes are required to just stay even. It has become a matter of survival for most companies.
As a result, companies have sought out methods for faster business process improvement. Moreover, companies want breakthrough performance changes, not just incremental changes, and they want it now. Because the rate of change has increased for everyone, few businesses can afford a slow change process. One approach for rapid change and dramatic improvement that has emerged is Business Process Reengineering (BPR).

Business Process Reengineering (BPR)

BPR relies on a different school of thought than continuous process improvement. In the extreme, reengineering assumes the current process is irrelevant - it doesn't work, it's broke, forget it. Start over. Such a clean slate perspective enables the designers of business processes to disassociate themselves from today's process, and focus on a new process. In a manner of speaking, it is like projecting yourself into the future and asking yourself: what should the process look like? What do my customers want it to look like? What do other employees want it to look like? How do best-in-class companies do it? What might we be able to do with new technology?
Such an approach is pictured below. It begins with defining the scope and objectives of your reengineering project, then going through a learning process (with your customers, your employees, your competitors and non-competitors, and with new technology). Given this knowledge base, you can create a vision for the future and design new business processes. Given the definition of the "to be" state, you can then create a plan of action based on the gap between your current processes, technologies and structures, and where you want to go. It is then a matter of implementing your solution.
In summary, the extreme contrast between continuous process improvement and business process reengineering lies in where you start (with today's process, or with a clean slate), and with the magnitude and rate of resulting changes.
Over time many derivatives of radical, breakthrough improvement and continuous improvement have emerged that attempt to address the difficulties of implementing major change in corporations. It is difficult to find a single approach exactly matched to a particular company's needs, and the challenge is to know what method to use when, and how to pull it off successfully such that bottom-line business results are achieved.

Reengineering Success Factors

More than half of early reengineering projects failed to be completed or did not achieve bottom-line business results, and for this reason business process reengineering "success factors" have become an important area of study. The success factors below are derived from benchmarking studies with more than 150 companies over a 24 month period.
Success factors are a collection of lessons learned from reengineering projects. Reengineering team members and consultants that have struggled to make their projects successful often say,
"If I had it to do over again, I would…" ,
and from these lessons common themes have emerged. In this module we examine these themes or success factors that lead to successful outcomes for reengineering projects. These include:
Top Management Sponsorship (strong and consistent involvement)
Strategic Alignment (with company strategic direction)
Compelling Business Case for Change (with measurable objectives)
Proven Methodology (that includes a vision process)
Effective Change Management (address cultural transformation)
Line Ownership (pair ownership with accountability)
Reengineering Team Composition (in both breadth and knowledge)

Top Management Sponsorship
Major business process change typically affects processes, technology, job roles and culture in the workplace. Significant changes to even one of these areas requires resources, money, and leadership. Changing them simultaneously is an extraordinary task. If top management does not provide strong and consistent support, most likely one of these three elements (money, resources, or leadership) will not be present over the life of the project, severely crippling your chances for success.
It may be true that consultants and reengineering managers give this topic a lot of attention. Mostly because current models of re-designing business processes use staff functions and consultants as change agents, and often the targeted organizations are not inviting the change. Without top management sponsorship, implementation efforts can be strongly resisted and ineffective.
Top management support for large companies with corporate staff organizations has another dimension. If the top management in the "line" organization and "staff" organization do not partner and become equal stakeholders in the change, AND you only have staff management support, you most likely are ill-prepared for a successful reengineering project (line management in this context are the top managers of the operation ultimately accountable for business performance -- P&L, customer service, etc.). Projects that result in major change in an organization rarely succeed without top management support in the line organization.

Strategic Alignment
You should be able to tie your reengineering project goals back to key business objectives and the overall strategic direction for the organization. This linkage should show the thread from the top down, so each person can easily connect the overall business direction with your reengineering effort. You should be able to demonstrate this alignment from the perspective of financial performance, customer service, associate (employee) value, and the vision for the organization.
Reengineering projects not in alignment with the company's strategic direction can be counterproductive. It is not unthinkable that an organization may make significant investments in an area that is not a core competency for the company, and later this capability be outsourced. Such reengineering initiatives are wasteful and steal resources from other strategic projects.
Moreover, without strategic alignment your key stakeholders and sponsors may find themselves unable to provide the level of support you need in terms of money and resources, especially if there are other projects more critical to the future of the business, and more aligned with the strategic direction.

Business Case for Change
In one page or less you must be able to communicate the business case for change. Less is preferred. If it requires more than this, you either don't understand the problem or you don't understand your customers.
You may find your first attempt at the business case is 100 pages of text, with an associated presentation of another 50 view graphs (overhead slides). After giving the business case 20 times you find out that you can articulate the need for change in 2 minutes and 3 or 4 paragraphs. Stick with the shorter version.
Why is this important? First, your project is not the center of the universe. People have other important things to do, too. Second, you must make this case over and over again throughout the project and during implementation - the simpler and shorter it is, the more understandable and compelling your case will be.
Cover the few critical points. Talk to the current state, and what impact this condition has on customers, associates and business results. State the drivers that are causing this condition to occur. State what your going to do about it (vision and plan), and make specific commitments. Keep focusing on the customer. Connect this plan to specific, measurable objectives related to customers, associates, business results, and strategic direction. Show how much time and money you need and when you expect to get it back. Don't sell past the close. No matter how long you talk, you will get resistance from some, and support from others, so you might as well keep it short.
The business case for change will remain the center piece that defines your project, and should be a living document that the reengineering team uses to demonstrate success. Financial pay back and real customer impact from major change initiatives are difficult to measure and more difficult to obtain; without a rigorous business case both are unlikely.

Proven Methodology
The previous module presented several BPR methodologies, and it is important to note that your methodology does matter. Seat-of-the-pants reengineering is just too risky given the size of the investment and impact these projects have on processes and people.
Not only should your team members understand reengineering, they should know how to go about it. In short, you need an approach that will meet the needs of your project and one that the team understands and supports.

Change Management
One of the most overlooked obstacles to successful project implementation is resistance from those whom implementers believe will benefit the most. Most projects underestimate the cultural impact of major process and structural change, and as a result do not achieve the full potential of their change effort.
Change is not an event, despite our many attempts to call folks together and have a meeting to make change happen. Change management is the discipline of managing change as a process, with due consideration that we are people, not programmable machines. It is about leadership with open, honest and frequent communication.
It must be OK to show resistance, to surface issues, and to be afraid of change. Organizations do not change. People change, one at a time. The better you manage the change, the less pain you will have during the transition, and your impact on work productivity will be minimized.

Line Ownership
Many re-design teams are the SWAT type -- senior management responding to crisis in line operations with external consultants or their own staff. It's a rescue operation. Unfortunately the ability of external consultants to implement significant change in an organization is small. The chances are only slightly better for staff groups. Ultimately the solution and results come back to those accountable for day-to-day execution.
That does not mean that consultants or staff are not valuable. What it does mean, though, is that the terms of engagement and accountability must be clear. The ownership must ultimately rest with the line operation, whether it be manufacturing, customer service, logistics, sales, etc.
This is where it gets messy. Often those closest to the problem can't even see it. They seem hardly in a position to implement radical change. They are, in a matter of speaking, the reason you're in this fix to begin with. They lack objectivity, external focus, technical re-design knowledge, and money.
On the other hand, they know today's processes, they know the gaps and issues, they have front-line, in-your-face experience. They are real. The customers work with them, not your consultants and staff personnel.
Hence your dilemma. The line operation probably cannot heal itself when it comes to major business re-design. Staff and consultants have no lasting accountability for the solution, and never succeed at forcing solutions on line organizations.
You need both. You need the line organization to have the awareness that they need help, to contribute their knowledge, and to own the solution and implementation. At the same time you need the expertise and objectivity from outside of the organization.
Building this partnership is the responsibility of the line organization, stakeholders and re-design team. No group is off the hook.

Reengineering Team Composition
The reengineering team composition should be a mixed bag. For example,
some members who don't know the process at all,
some members that know the process inside-out,
include customers if you can,
some members representing impacted organizations,
one or two technology gurus,
each person your best and brightest, passionate and committed, and
some members from outside of your company.
Moreover, keep the team under 10 players. If you are finding this difficult, give back some of the "representative" members. Not every organization should or needs to be represented on the initial core team. If you fail to keep the team a manageable size, you will find the entire process much more difficult to execute effectively.

IT's Role in Business Process Reengineering Initiatives
By some estimates, over seventy percent of today's companies are performing business process reengineering (BPR). BPR realigns business processes along more strategic lines by examining current processes and redesigning those processes to increase efficiency and effectiveness. As more organizations launch BPR projects, one issue becomes painstakingly clear. Radically altering business processes within highly automated work environments typically requires modification to the information systems that support those processes.
Information technology (IT) organizations have had significant difficulty meeting the BPR challenge due to the inherent complexities involved in "retooling" complex legacy environments. In order to more effectively respond to BPR retooling demands, IT must play a more active role throughout a BPR project. IT must:

Increase their level of participation in all areas of a BPR initiative;

Provide key information regarding automated processes to business analysts;

Build a transition strategy that meets short and long-term retooling requirements;

Enforce the integrity of redesigned business processes in the target system;

Reuse business rules and related components that remain constant in a target application.
Factors driving a BPR project can include improving customer service, streamlining processes to cut costs, or addressing inefficiencies in other high impact areas. For example, customers frustrated with having to speak to multiple individuals regarding an insurance claim may switch to the competition. To address this problem, an insurance provider determines that service functions must be consolidated to one point of contact. The underlying systems that manage claims handling do not support single point of contact processing. In this case, legacy systems have become a barrier to the success of the BPR initiative.
Regardless of the motivating factors, creating an implementable retooling plan to support a BPR project remains a frustrating, yet essential, challenge to IT organizations. Retooling strategies can include surround technology, off-shore rewrites, redevelopment of impacted systems, webification and package acquisition. Surround strategies, like the creation of graphical user front-ends or a data warehouse, provide some near-term benefit, but tend to ignore fundamental problems with stovepipe information architectures.
Off-shore projects, which involve shipping a system overseas, typically focus on a technical rewrite of a system. Redevelopment of impacted applications normally couples redesign of the technical architecture with redefinition of system boundaries and addition of new functionality. Linking business functions to the internet still requires managing and synchronizing legacy data and applications. As for software packages, organizations must invest adequate time to determine if a package meets BPR requirements and the amount of customization required if it does not. The applicability of each of these approaches must be analyzed on a case-by-case basis.
To determine retooling strategies, a relationship between IT and the business must be formalized early on. This relationship, which supports BPR analysis and implementation, is reciprocal because business and technical analysts must devise a continuous feedback communication loop for projects to work. This is particularly critical because current systems analysis helps articulate the as-is business model while the redesigned business model dictates the impact BPR has on existing information architectures. Once this reciprocal cycle is in place, IT can determine exactly how to upgrade, redesign, or replace selected systems in order to implement reengineered business processes. Figure one highlights key steps in a retooling strategy.

BPR Retooling Steps
1. Define strategy, select modeling methodology & establish BPR project plan
2. Build as-is business model for impacted business areas based on strategic vision
3. Refine / expand as-is model for all processes supported by existing systems
4. Integrate as-is process definitions with current system functions & components
5. Finalize functional and technical architecture required to meet BPR objectives
6. Select retooling strategy to redevelop, surround, acquire, webify or off-load applications
7. Maintain design integrity between business requirements and retooled applications
8. Reuse applicable components including rules, interfaces & data in target application
9. Validate retooled application against initial simulation of redesigned processes
IT Plays Key Role in Assessing Changing Business Requirements
Being able to determine appropriate retooling strategies requires that individuals with knowledge of the information architecture be on the BPR team. Early and ongoing involvement of IT personnel benefits all aspects of the project. Initial IT involvement focuses on discovery. If a process is to be fully understood, and portions of that process are automated, analysis of underlying applications facilitates the completion of the as-is business process model.
Organizations need to develop an organic blueprint of the business to create widespread awareness of vision and a common understanding of how the organization functions. This includes defining the organizational units, processes, resources, and interactions between each of these objects. One approach might be to use Ivar Jacobson’s ‘Use Case’ techniques. Use Case defines stakeholders within an organization and their relationship with various objects.
Use Case modeling was first defined in Jacobson’s book Object-Oriented Software Engineering. A major benefit of Use Case is that it offers a simplified notation for users. Use Case facilitates the expression of business events and objects impacted by those events. Modeling a complete business process is more intuitive when it can be bounded by tangible events. For example, a process begins when a customer places an order and ends when an order is received and payment is made. Use Case is also an excellent way of representing roles within a business model.
Because Use Case integrates with object-oriented techniques, it bridges the gap between strategic business modeling and the systems specification process. This gap has historically resulted in system designs that do not support BPR requirements. To that end, some vendors have automated Use Case modeling to support techniques such as the Booch object-oriented method.
Traditional business process modeling techniques are not as powerful as object-oriented techniques in terms of being able to break down complex systems. Traditional models also do not provide the same level of flexibility, emphasis on reuse, and intuitive link to software design models. Organizations using traditional BPR techniques can end up with rigid models that are unnecessarily redundant and complex. This should be considered when defining the business model and create a cross functional systems design.
While many people agree with the goal of developing flexible, reusable process models that can interface directly with system design models, some challenge the view that object modeling is the best approach. While object-oriented models are mathematically correct, it is non-trivial to follow them. This is particularly true for the non-technical business user.
One approach involves storing business processes and interactions in an automated facility designed to manage those processes. Each process may then be decomposed into the user interface required to implement that process. This requirements model is easy to understand, helps visualize a target system, and actually becomes the front-end design. Another issue typically ignored during a BPR project is that process redesign tends to be an ongoing effort at many companies. Using a process automation tool provides flexibility to business analysts and users who must update business process models on an ongoing basis.

Existing Architecture Must be Mapped to Business Model
One major IT requirement involves mapping the existing information architecture to the business model to accurately depict current processes. Historically, companies could separate business operations and underlying technology. This distinction is no longer possible. Both areas must be analyzed in an integrated fashion to understand current business processes. This involves analyzing the systems, as well as human interaction with those systems. This includes reviewing system functions, user interfaces, operational procedures, and the often convoluted process of data sharing.
The method used by IT analysts to refine the as-is process model requires documenting current functions and presenting the information in a way that can be integrated into the business model. For example, if order processing is being reengineered, analysts must review system functions that initiate, register, process, deliver, bill, and collect payment for an order. In many legacy architectures, these functions are scattered across numerous standalone or stovepipe systems.
IT-based analysis involves building an inventory of all impacted systems and includes system name, location, operating environment, owner, interfaces, and programs. This inventory should be established at a subsystem level where applicable. The information collected here can be tracked using spreadsheets or in an open repository using a standardt ransition model. While a formal repository representation of a transitional model is more robust, the spreadsheet is a good communication vehicle for users.
The transition model can be established using standard repository technology. Additionally some products include a database that allows analysts to store information about a system. In some of these products, meta-data can be depicted in an object model that can then be used to model business processes. This integrated view, coupled with the ability to layer objects, allows business analysts to view summary information and IT analysts to view the physical detail.
Building a base of information that defines an existing information architecture requires working with systems analysts to identify which pieces of which systems support key business functions. A function is "a group of business activities which together completely support one aspect of furthering the mission of the enterprise". Research can be done through interviews with system subject matter experts or through interrogation of interfaces, including screen and report headings. This process is called "reverse requirements tracing" and is most effective when results are verified with subject matter experts.
Legacy functions are mapped into the transition model as they are identified. The research process focuses on those systems that contain functions that support the processes defined in the business model. Each function, as it is discovered, is linked to the business process it supports. That function is then linked to the user interfaces that implement or initiate it. Interfaces include on-line screens, batch reports, and job control streams. User interfaces can be linked to the programs that implement that function during the implementation phase - depending on the retooling strategy.
Analysts continue to link business processes to functions, and functions to physical components, until all automated processes in the business model are mapped. The reason a business process is linked to an extracted function as an interim step in the transition model is due to legacy system limitations. Functions, normally scattered across stovepipe systems, are extracted from complex legacy interfaces. Creating an interim mapping is therefore easier than trying to relate legacy components directly to process-driven business models.

Retooling Strategy Must Consider Legacy Architecture Evolution
In any BPR project, the as-is model should be used as a basis to redesign workflows. As processes are eliminated, updated, added, and re-sequenced, links to legacy system functions are maintained in the transition model. The modeling approach used can be flexible, because the open transition model supports mapping of legacy functions to object, user interface, or other types of models. Upon completion of the new business model, work can begin on the retooling strategy. This requires an assessment of the existing architecture and target requirements which results in a detailed, retooling implementation plan.
The first step in the assessment requires management to identify feasible retooling hypotheses. This includes surround strategies, redevelopment, offshore options, internet options and / or package acquisition. Several basic issues drive which hypotheses are considered. An immediate requirement to address customer service consolidation may necessitate surround technology, such as graphical front-ends or data warehouse. An offshore rewrite could also serve as an interim strategy to stabilize a weak system. Additionally, selected off-the-shelf packages may meet retooling requirements. Finally, redeveloping impacted systems may be the ideal long-term solution to meet BPR requirements.
Regardless of the approach, the transition model can be used to support detailed analysis, design, and implementation. The analysis needed to finalize the retooling plan includes maintaining links between business models and detailed design models, further decomposition of legacy functions, and mapping legacy functions to detailed target models. The type and depth of analysis depends on the strategy being examined. Fore xample, requirements mapping to a package compares package models with target and legacy design models to determine reuse, deactivation, integration, and migration requirements.
Full-scale redevelopment, depending on the target architecture, requires detailed extraction and reuse of existing business rules. Extracted business rules must be mapped, at the applicable level of detail, to target design models. Augmentation of target models, and reuse of key business rules, can significantly streamline redevelopment cycles and shorten implementation windows. Many of the existing business rules can be reused under a target architecture. Organizations are spending a lot of money trying to recreate business rules when they don’t have to.
These concepts challenge traditional BPR retooling strategies which include surrounding impacted systems or undertaking a complete rewrite. The first approach ignores the fact that underlying architectures remain segregated and convoluted. The second approach rarely accommodates legacy migration requirements and tends to exceed delivery windows and budget plans. Selecting a common sense approach, based on detailed analysis of target and existing architectures, yields the best results.
Several redevelopment options can be applied as a way to retool legacy architectures. Regardless of the approach, systems should be phased in over time, while deactivating legacy components along the way. One approach is to create a system to support the cross section of the business being reengineered. In the order processing example, this means mapping all business rules extracted from multiple standalone systems to a target design model. Rule extraction is accomplished using a combination of slicing and cross-system extraction tools.
Another approach, applying similar techniques, performs multi-system integration on all relevant systems. This approach retools the existing architecture on a broad scale. The focus is on mapping legacy to target design models, rule reuse, redundant rule consolidation, legacy deactivation, and transition management. Both approaches require phased decomposition of existing systems into reusable business logic, data access, and communication segments. Data store consolidation and redesign is performed concurrently. The transition model plays an active and critical role throughout the implementation process.
Internet utilization requires an assessment of the role of legacy data and functionality. Leveraging the Internet requires more than setting loose scores of para coders. Redevelopment offers this broader view of the issue and the solution. Even package strategies require a retooling component. Legacy systems must be inventoried, deactivated, and integrated as part of package implementation. If the package requires retooling, redevelopment techniques may be applied after implementation. Any of these longer term approaches can be coupled with a parallel, interim surround strategy to deliver value near-term.
While it is true that BPR retooling efforts, a relatively new endeavor for IT, have stumbled in the past, this no longer needs to be the case. Following a few basic guidelines, along with education on the tools and techniques that support the process, allows managers to evaluate more options and make more informed retooling decisions in the long run. As IT moves up the retooling maturity curve, realistic interim and long-term retooling options should become the norm.

Reengineering Recommendations
BPR must be accompanied by strategic planning, which addresses leveraging IT as a competitive tool.
Place the customer at the center of the reengineering effort -- concentrate on reengineering fragmented processes that lead to delays or other negative impacts on customer service.
BPR must be "owned" throughout the organization, not driven by a group of outside consultants.
Case teams must be comprised of both managers as well as those will actually do the work.
The IT group should be an integral part of the reengineering team from the start.
BPR must be sponsored by top executives, who are not about to leave or retire.
BPR projects must have a timetable, ideally between three to six months, so that the organization is not in a state of "limbo".
BPR must not ignore corporate culture and must emphasize constant communication and feedback.

CONCLUSION
Reengineering efforts must be clearly connected to actual business, market, and organization strategy. Easier said than done! If that connection isn't made and maintained, no amount of communication can compensate. Reengineering "ownership" must be broadened to include human resource executives, who are busy with their own renewal initiatives. It must also build a stronger base with employees battered by more than a decade of downsizing. The reengineering movement has spent only a small fraction of what quality improvement has on employee education. Along the same lines, reengineering champions should give more thought to how their programs and projects should ideally be integrated with other important improvement efforts like quality leadership, customer satisfaction and retention, and economic value added (the Stern Stewart model). BPR will be regarded as another tool for management to "pad" its short-term results instead of doing its essential task of innovation, market creation and growth. At the moment, there's nothing poised on the horizon to end the popularity of BPR. Unless these broader issues are addressed, however, you can be sure something will turn up

Mergers and Acquisitions: Boon or Bane?

courtesy:Gary E. Mullins, Ph.D.
University of Wisconsin - Stevens Point


Introduction
There have been a large number of mergers and acquisitions affecting the economy both locally and nationally*. Here are a few recent examples:



• Consolidated Paper and Stora Enso

• Thompson and Gannett Newspaper Chains

• Saint Michael’s Hospital/Ministry Health Care and Rice Clinic

• Wausau Insurance and Liberty Mutual

• Wisconsin Central and Canadian Pacific Railroad

• M&I Bank and National City Bancorporation

• Sentry Insurance and John Deere Insurance Group

• Copps and Roundy’s

• All-Car Distributors, Inc. and CSK Auto Corporation

• Marshfield Clinic and Wausau Hospital

• Nortek/Peachtree Companies and SNE Enterprises

• Exxon and Mobil Oil Corporation



These corporate combinations raise a number of questions:

• What are the mechanics of mergers and acquisitions?

• Is this merely another example of corporate greed?

• Why do mergers and acquisitions occur?

• What are the impacts associated with mergers and acquisitions?



This report addresses these and other questions by looking at the trends in Central Wisconsin and in the nation as a whole.





Definitions and Mechanics of Mergers and Acquisitions

A merger2 is a general term for the combination of two or more companies. Strictly speaking, only a corporate combination in which one of the companies survives as a legal entity is called a merger. These corporate combinations can be accomplished in three different ways: by pooling of interests, by purchase acquisition, or by consolidation.

A pooling of interests is generally accomplished by a common stock swap at a specified ratio. For example when M&I Bank11 merged with National City Bancorporation, the common stock of the two companies were swapped at a ratio between 0.65556 and 0.53636 shares of M&I for every share of National City Bancorporation. This is sometimes called a tax-free merger. Such mergers are only allowed if they meet certain legal requirements. Pooling of interests is less common than purchase acquisitions.

Purchase acquisitions involve one company purchasing the common stock or assets of another company. In a purchase acquisition, one company decides to acquire another, and offers to purchase the acquisition target’s stock at a given price in cash, securities or both. This offer is called a tender offer because the acquiring company offers to pay a certain price if the target’s shareholders will surrender or tender their shares of stock. Typically, this tender offer is higher than the stock’s current price to encourage the shareholders to tender the stock. The difference between the share price and the tender price is called the acquisition premium. These premiums can sometimes be quite high. In the case of the Stora Enso acquisition12 of Consolidated, the $44 per share offer represented a 69% premium over Consolidated’s February 18, 2001 closing price. Why was Consolidated’s common stock worth 69% more to Stora-Enso than it was to the market prior to the acquisition’s announcement? This is an excellent question that will be addressed in the section dealing with the economic impact of corporate combinations.

The third method of corporate combinations is consolidation. In a consolidation, the existing companies are dissolved, a new company is formed to combine the assets of the combining companies, and stock in the consolidated company is issued to the shareholders of both companies. The Exxon merger with Mobil Oil Company is technically a consolidation. This merger is interesting from an historical perspective because it, in part, reverses the antitrust judgement against the old Standard Oil Trust.

Other terms to be defined are the horizontal, vertical and conglomerate5 mergers. Horizontal mergers occur when a company merges with another company who is a direct competitor in the same product lines and markets. A vertical merger occurs when a company merges with either a supplier or a customer. Conglomerate mergers occur when the companies combined have no relationship to each other.



Why Do Mergers Occur?

There are a number of reasons that mergers and acquisitions occur. These issues generally relate to business concerns such as competition, efficiency, marketing, product, resource, and tax issues. They can also occur because of some very personal reasons such as retirement and family concerns. However, let’s begin our exploration of why corporate combinations occur by discussing an often-cited reason - corporate greed.



Corporate Greed?

Some people say that mergers and acquisitions occur because the greedy corporations want to acquire everything. As far as economic theory is concerned, the primary objective of a firm is to maximize profits, and thereby maximize shareholder wealth.** We can argue about the firm’s approach to maximizing profits (e.g., whether being a good corporate citizen increases profits long term, etc.), but any firm, corporation or not, should make decisions designed to increase its profits.

At this point, I am usually accused of paraphrasing the character, Gordon Gecko in the movie Wall Street, who said, “Greed is good.” I am not saying greed is good; I am saying that the desire for more rather than less is an integral part of the human psyche. When Samuel Gompers17, the father of the American labor movement, was asked what the members of his union wanted, he didn’t say that they wanted some sort of utopia in which everyone got his or her fair share. His response was one simple word, “More!” Ronald Coase, the Nobel Prize-winning economist, once stated, “I have devoted my life to the proposition that economic agents prefer more money to less, and I have found a surprising amount of evidence supporting this proposition.”

However, the interesting thing about studying mergers and acquisitions is that it appears that corporations sometimes make decisions that run counter to Coase’s proposition. As we shall see when discussing the economic impact of corporate combinations, firms sometimes make decisions that seem to lessen shareholder wealth.

Specific Reasons Why Mergers and Acquisitions Occur

(Other Than Greed)

Eliminate Competition

One important reason that companies combine is to eliminate competition. Acquiring a competitor is an excellent way to improve a firm’s position in the marketplace. It reduces competition, and allows the acquiring firm to use the target’s resources and expertise. Unfortunately, combining for this purpose is per se illegal under the antitrust acts2 as a predatory practice in restraint of trade. Consequently, whenever a merger is proposed, a major part of the resulting press release often deals with how this combination of firms is not anti-competitive, and is done to better serve the consumer. Even if the merger is not for the stated purpose of eliminating competition, U.S. regulatory agencies may conclude that a merger is likely to be anti-competitive. For example, Canadian National’s attempt to merge with Burlington Northern Santa Fe6, 8 was blocked because of concerns that the combination would prompt a series of mergers and acquisitions whose net effect would be to leave the continent with only two transcontinental railroads. Although eliminating competition may result in merger and acquisition activity, it is generally not acceptable to state this as the purpose of such activity. However there are a number of acceptable reasons for combining firms. Let’s now examine them.

Cost Efficiency and the Long-Range Average Cost Curve

Due to technology and market conditions, firms may benefit on a cost basis from being a certain size. Clearly, one way to grow is to combine with other small firms until the firm is optimally sized. Generally, the assumption is that larger firms are more cost-effective than are smaller firms (i.e., that larger firms exhibit economies of scale when compared to smaller firms). This is often the stated motive10 for mergers in the financial services industry.

It is, however, not always cost effective to grow in the financial services industry. In this industry, the long-run average cost curve appears to be virtually flat4 for financial institutions having total assets of greater than $10 to $20 million. This suggests that in spite of financial institutions’ stated reason that merging will improve cost efficiency, larger financial institutions are not necessarily more efficient than smaller institutions. Further, there is some evidence to suggest that very large financial institutions exhibit diseconomies of scale. This means that the average cost per unit increases, as total assets grow too large. Some analysts have suggested that the management may be merging to increase their own prestige. Clearly, managing a company with assets of $100 million is more prestigious than managing a company with assets of $50 million.

How to Avoid Being a Takeover Target by Investing Existing Funds

This is a two-part reason that companies merge. If firm A has a great deal of liquid assets, it becomes a tempting takeover target because the acquiring firm can use the liquid assets to expand the business, pay off shareholders, etc. If A invests existing funds in a takeover, it has the effect of discouraging other firms from targeting firm A because A has increased in size, and will require a larger tender offer. Thus, the company has found a use for its excess liquid assets, and made itself more difficult to acquire. Often firms will state that acquiring a company is the best investment the company can find for its excess cash. This is the reason given for many conglomerate mergers.

Improve Earnings and Sales Stability

Improving earnings and sales stability are concerned with reducing corporate risk. If company A has some sort of earnings or sales instability, merging with company B may reduce or eliminate the instability provided company B’s instability is negatively correlated with company A’s instability. Suppose company A manufactures lawnmowers. Suppose further that company B manufactures snow blowers. Thus, company A makes money in the summer while company B makes money in the winter. If the companies are approximately the same size and have approximately the same sales, then by merging, they can eliminate the seasonal instability. Unfortunately, this is an economically inefficient way of eliminating instability.

Market/Business/Product Line Issues

Often mergers occur simply because one firm is in a market that another wants to enter. All of the target firm’s experience and resources (the employees’ expertise, business relationships, etc.) are available by buying the targeted firm. This is a very common reason for acquisitions. For example, Monsanto*** acquired G.D. Searle because Monsanto wanted to acquire the pharmaceuticals and consumer chemicals (Aspartame) businesses. Sentry Insurance13 acquired John Deere Insurance Group to enter the market for insuring implement dealers, and transportation. CSK Automotive7 purchased All-Car to have access to the Central Wisconsin automotive parts market. Similarly, Canadian National purchased Wisconsin Central6 to enter the U.S. rail market. Whether the market is a new product, a business line, or a geographical region, market entry or expansion is a powerful reason for a merger.

Closely related to these issues are product line issues. A firm may wish to expand, balance, fill out or diversify its product lines. For example, merger and acquisition activities of Nortek/Peachtree Companies15 are primarily product line related.

Acquire Needed Resources

One firm may simply wish to purchase the resources of another firm or to combine the resources of the two firms. These resources may be tangible resources such a plant and equipment, or they may be intangible resources such as trade secrets, patents, copyrights, leases, etc., or they may be talents of the target company’s employees. One reason given for the mergers in the petroleum industry is that companies wish to acquire the leases of their competitors. If acquiring a company for its talent seems strange, consider that Cisco Systems CEO John T. Chambers5 said, “Most people forget that in a high-tech acquisition, you are really only acquiring people… We are not acquiring current market share. We are acquiring futures.” This and the previous section emphasize that often the reasons for mergers and acquisitions are quite similar to the reasons for buying any asset. Both firms and individuals purchase an asset for its utility.

Synergy

Synergy, a term made popular in the 1960’s, states that there are efficiencies gained in all the things you do because you do more than one thing. The related popular catch phrase of the time was “two plus two equals five.” Synergy is similar to the concept of economies of scope. Economies of scope would occur if a meat processing company merged with a leather goods manufacturer, and the combined company was more cost efficient at both activities because each requires the same raw material. Although synergy is often cited as the reason for conglomerate mergers, cost efficiencies due to synergy are difficult to document.

Corporate Tax Savings

Although tax savings2, 3 may not be a primary motivation for a combination, it can “sweeten” the deal. When a purchase of either the assets or common stock of a company takes place, the tender offer less the stock’s purchase price represents a gain to the target company’s shareholders. Consequently, the target firm’s shareholders will usually experience a taxable gain. However, the acquiring company may reap tax savings depending on the market value of the target company’s assets when compared to the purchase price. The acquiring company can write up the target company’s assets by the amount that the market value exceeds the net book value of the target company’s assets. This difference can then be charged off to depreciation with resultant tax savings. This differs from goodwill in that goodwill is never tax deductible. Depending on the method of corporate combination, further tax savings may accrue to the owners of the target company.

Retirement or Cashing Out

For a family-owned business, when the owners wish to retire, or otherwise leave the business, and the next generation is uninterested in the business, the owners may decide to sell to another firm. Retirement or cashing out is locally rumored to be the motivation in the sale of Copps to Roundy’s; however, I have been unable to find this explicitly stated by either company in any press release.

For purposes of retirement or cashing out, if the deal is structured correctly, there can be significant tax savings. By using the pooling method, the sellers may be able to account for their sale of their interest3 as a tax-free exchange. Provided the sellers receive common stock of the purchasing company in exchange for their interest, they can assign the book value of their former investment to the shares received. Therefore, no tax would be due until the shares received are sold. Interestingly, the Copps/Roundy’s deal appears to be a straight purchase14 of shares of about $95 million to about 60 Copps shareholders, and would therefore not have this benefit.

The Impacts of Mergers and Acquisitions

What impacts do mergers and acquisitions have? As any good economist would tell you, the answer is, “it depends.” First, it depends on the group of people being discussed. It may also depend on how the deal is structured. Let’s discuss each of the various groups involved.

Economic Impacts: Employees

For the employees, being in a merger can be extremely difficult. Generally speaking, when companies merge, there are often layoffs. This was the case for Stora Enso and many of the other companies studied. If the merged company is truly more efficient in a business sense (if not a financial sense), then the merged company will not need to employ as many workers to do the same amount of business. Sometimes, these layoffs are not terribly severe; further, such layoffs may be accomplished by attrition. If the economy is good, and the laid off employees have up to date skills, they may actually benefit from moving. However, typically, the employees laid off are the least valuable to the company, which means that they may be lesser valued to potential employers. Locally, laid off workers may not find the opportunities available to them as financially appealing as the jobs they left. This has a negative impact on the local economy. Although there may not be severe unemployment because jobs are available, the new jobs may not pay as well for lesser-skilled employees. This can have a ripple effect throughout the economy due to decreased incomes for laid off workers.

For the employees who stay, matters may not be much better. Rarely will the merged company have a similar corporate culture. Indeed, the corporate culture may be drastically different. Changes in business procedures and operating environment can result in severe stress, and, in extreme cases, may lead employees to suffer both emotional and physical problems.

Economic Impacts: Management

The management ranks may suffer more job loss, on a percentage basis, than the employees may. In part, this is due to the clash of corporate cultures. Managers may be charged with implementing corporate polices they might disagree with on behalf of superiors they don’t like to employees who may resist change. This is a recipe for high levels of stress. Further, when a company is merged, it doesn’t need redundant managers. This means that an existing manager must be either terminated or demoted. Because it may be difficult to defer to someone else when you are used to being in command, demoted managers may also leave. If their skills are up to date, leaving may actually improve a manager’s prospects. Although lower levels of management do not benefit from golden parachutes, often, top management has such benefits written into their contracts. Unfortunately, these practices further exacerbate the financial inefficiencies we will discuss in the next section.

Economic Impacts: Shareholders

If the deal is a purchase, the acquired firm’s shareholders benefit greatly1 from the acquisition. The reason for this is that in almost every case the acquiring firm pays too much for the acquisition. If company A purchases company B, the resulting company will have a lower value than the value of the independent companies summed.

One reason for this overpayment is asymmetric information. The purchasing firm simply doesn’t understand what it is buying. Consider purchasing a house. Until the new owners have lived in a house, they probably do not understand all of the quirks associated with the house. Some rooms may be hot or cold, or the basement may leak in the spring. No amount of inspection can reveal all of the problems. The mechanics of the purchase is another reason that acquiring firms spend too much. In order to induce the existing shareholder to relinquish their shares, the acquiring firm has to pay more than the current share price. Because the acquiring company pays too much, the sale of a company with a lot of local shareholders can benefit the local economy. The sale of Consolidated to Stora Enso should benefit central Wisconsin by an infusion of cash12 from abroad. Unfortunately, this benefit must be weighed against the negative impacts on the managers and other employees.

The economic impact for the purchasing firm’s shareholders is strikingly negative. A number of studies have shown that they suffer by at least the same amount that the target firm’s shareholders benefit. This is due to the acquisition premium as well as the increased debt load and inefficiencies typically accompanying a purchase acquisition. The reasons given by the acquiring firm’s management for the acquisition are often similar to those already covered (more efficient size, product line issues, acquire needed resources, etc.). Whether these reasons would justify the loss due to the acquisition premium has been a subject of study.

A number of studies have attempted to prove that the benefits above offset the acquisition premium. Unfortunately, these studies have almost uniformly concluded that the acquiring firm is strongly negatively impacted by the acquisition. It should be noted however, that this has been challenging to prove because there are other factors impacting the acquiring company’s stock price-general economic upturns, industry-specific news, etc.-which are difficult to separate from the impacts due to the merger. Alternatively some studies have evidence suggestive of positive benefits; unambiguously documenting such benefits, however, has been elusive.

Stora Enso’s bid for Consolidated was 69% higher than the previous day’s closing12 stock value. It is difficult to imagine how better management would offset such a premium. This again raises the question, “why was Consolidated’s common stock worth 69% more to Stora-Enso than it was to the market prior to the acquisition’s announcement?” The empirical evidence argues that Consolidated should not have been worth that much to Stora Enso while Stora Enso’s management says that the acquisition was financially justified. The answer to this question is still unclear. Although Stora’s premium may be unusually high, it is not uncommon to see acquisition premiums of 25% or more. Indeed, a good trading strategy would be to purchase the shares of likely takeover candidates. Getting back to the issue of greed, paying such premiums suggests that managers may make decisions that do not benefit its shareholders.

What happens if the merger takes place by pooling assets? In this case, the impact of asymmetric information is lessened because the assets of both firms are combined, and there is not as much inefficiency. In other words, there is asymmetric information on both sides that somewhat offsets each other. That is, if company A overvalues company B’s assets, and at the same time company B overvalues company A’s assets, the two overvalues make the stock swap for the pooling approach more closely reflect the appropriate values for the combined company.

Any corporate combination, however, is fundamentally economically inefficient. Think about combining the assets of a couple getting married. There are two of everything. Also, each person does things differently. Combining two or more firms is not as economically efficient as an individual investor’s purchasing the shares of the companies for her portfolio.

Economic Impacts: What about Competition?

What we haven’t talked about is the competitive business environment. Are we heading toward an economy with just a few mega-corporations that control everything? What will happen to the small competitor? The answer depends on the industry’s technology and capital structure. For example, some interesting statistics presented at a recent banking seminar at UW-Madison showed that while the rate of mergers was increasing, the overall number of competitors in the financial services industry has remained relatively constant. This suggests that as combinations are reducing the number of competitors, new competitors enter the market. Naturally, these results are industry-specific. For example, it’s hard to imagine a mom-and-pop railroad. To be cost efficient, perhaps firms will need to be either extremely small or extremely large. The extremely small firms are like the startup firms in the computer industry 25 years ago. Then, a few kids ran Microsoft and IBM exerted near-monopoly control over the industry. Now, Microsoft is the one fighting the antitrust battles, and IBM is not the power it used to be. The climate for entrepreneurs has never been better, and the economy will be competitive as long as it is open to entrepreneurs with better ideas who can figure out better ways to do things.

What about Debt?

When individuals wish to purchase a house, they often (almost always) go into debt. The assumption is that future earnings will be enough to pay off the debt. According to a source in the banking industry, house loans now may be almost as great as the value of the house. Occasionally, people miscalculate, forecast incorrectly or face an economic downturn, because their income is not sufficient to pay off the debt, and they declare bankruptcy. This is unfortunate, but no one says that we should avoid debt for large acquisitions such as houses or cars. Similarly, corporations sometimes make an acquisition with the assumption that their future earnings will be enough to pay off the debt. Like individuals, corporations sometimes miscalculate, forecast incorrectly or face an economic downturn. This can result in the bankruptcy of the corporation in the same way that it does for individuals.

Economic Impacts: Economic Colonization?

Economic colonization relates to the question, “What will happen if the outsiders come in and take away all our jobs?” This concern ignores the concept of comparative advantage, which states that if each person or country specializes in what it does comparatively best, the entire global economy will improve. If companies in Wisconsin can produce more efficiently than companies in other places, then the production will occur in Wisconsin. This, of course, assumes a level playing field. That is, it assumes that foreign countries do not unfairly subsidize their industry, markets are allowed to work, and so on. Policing the local as well as international market is an important legitimate function of government, as is providing programs to update the skills of the workforce that may be displaced by market changes. With those caveats, foreign acquisitions probably produce a positive net impact on local economies for several reasons.

The first is, of course, the comparative advantage argument discussed above. Also, with foreign acquisitions, the capital goods acquired by foreigners will stay here, as will foreign money spent to acquire the local companies. In the 1980’s, when Japanese companies were acquiring American landmarks such as the Empire State Building and Rockefeller Center there was a tremendous uproar. However, those landmarks are still here (at least they were the last time I was in New York), and the Japanese yen spent to purchase them was paid to shareholders in the U.S. Consider what happens when a tourist comes into central Wisconsin and spends money on cheese, it is seen as a great boon for the economy. Stora Enso spent $4.9 billion12 to buy a local company. I think that that is also a net benefit for central Wisconsin. As for jobs being for sale, any job is for sale at the right price. Even my job is for sale if someone is willing to pay the right price to UWSP and to me.

Summary

This paper has discussed mergers and acquisitions in central Wisconsin. It has reviewed the basic mechanics of corporate combinations and the reasons (both legitimate and illegitimate) that such combinations occur. We found that corporate combinations are similar to the kinds of combinations and acquisitions that individuals often undertake in their everyday lives. Further, acquisitions are often made for solid business reasons. Although the acquisition may be made for sound and understandable reasons, the acquiring company typically pays too much. This is due to asymmetric information and the mechanics of a tender offer. We also reviewed the economic impacts of mergers and acquisitions on the employees, management, shareholders, and the competitive economic environment. We found that the impact of mergers and acquisitions are mixed - generally positive for the target firm’s shareholders, but negative for the acquiring firm’s shareholders as well as the resulting company’s employees and management. One final caveat is that each acquisition is complex with its own unique set of costs and benefits.

Low cost airline - overview

1. Indian Airline Industry – An Introduction
Air transportation in India is under the purview of the Department of Civil Aviation, a part of the India's Ministry of Civil Aviation and Tourism. In 1995 the Indian government owned two airlines and one helicopter service, and private companies owned six airlines.
The government-owned airlines dominated India's air transportation in the mid-1990s. Air India is the international carrier; it carried more than 2.2 million passengers in FY 1992. Indian Airlines is the major domestic carrier and also runs international flights to nearby countries. It carried 9.8 million passengers in FY 1989, when it had a load factor of more than 80 percent in its fifty-nine airplanes. Analysts, however, attributed this high load factor to a shortage of capacity rather than efficiency of operation. A major expansion was planned for the 1990s, but an airplane crash in 1990 and a pilots' strike in 1991 damaged the airline, which carried only 7.8 million passengers in FY 1992. Two other accidents in 1993, plus several hijackings, put constraints on the growth of both airlines.
A third government-owned airline, Vayudoot, was also a domestic carrier in the early 1990s. It provided feeder service between smaller cities and the larger places served by Air India and Indian Airlines. By 1994 Indian Airlines had taken over Vayudoot. Another publicly owned company, Pawan Hans, runs helicopter service, mostly to offshore locations and other areas that cannot be served by fixed-wing aircraft.
In 1995 India's six private airlines accounted for more than 10 percent of domestic air traffic. Both the number of carriers and their market share are expected to rise in the mid-1990s. The four major private airlines are East West Airlines, Jagsons Airlines, Continental Aviation, and Damania Airways.
In addition to the Indian-owned airlines, many foreign airlines provide international service. In 1995 forty-two airlines operated air services to, from, and through India.
In the mid-1990s, India had 288 usable airports. Of these, 208 had permanent-surface runways and two had runways of more than 3,659 meters, fifty-nine had runways of between 2,400 and 3,659 meters, and ninety-two had runways between 1,200 and 2,439 meters. There are major international airports at Bombay, Delhi, Calcutta, Madras, and Thiruvananthapuram (Trivandrum), under the management of the International Airport Authority of India. International service also operates from Marmagao, Bangalore, and Hyderabad. A consortium of Indian and British companies signed a memorandum of understanding with the state government of Maharashtra in June 1995 to build a new international airport for Bombay, across the harbor from the main city and to be linked by a cross-harbor roadway. Major regional airports are located at Ahmadabad, Allahabad, Pune, Srinagar, Chandigarh, Kochi, and Nagpur.
Budget Airlines
It took some time for the budget airline industry to catch on in India. The concept originated in the west and was quickly picked up in the East Asian countries. Richard Branson of Virgin Airlines was the front runner in Britain, while Qantas took the major chunk of the Australian budget skies. In the post- WTC days of aerial terror, seat occupancies in established carriers crashed, leaving them to operate on losses. That was the time when the wallet-friendly carriers took off and still operated with profit margins. The non-frillers were characterized by few on-board services, elimination of catering and assistance services and little inflight glitz.
2. Air Deccan – The low cost air line carrier
India’s low cost airline carrier Air Deccan is the first to offer low airfares through a model similar to American airline Southwest. However, there’s a lot more behind Southwest’s success than just low costs; a detail that Air Deccan is quickly realizing; were quick to dismiss the concept as non-workable but the brand soldiered on and is now fairly popular.
The airline’s position of strength is in rock bottom rates; none of the larger airlines have figured out how to counter the fledgling airline’s pricing advantage. Virtually a monopoly in this category of economy flights, Air Deccan can celebrate as long as it remains unchallenged. However, the brand seems unprepared to take on competition and many aspects of the offering seem poorly managed.
Having done little to prepare customers for the brand experience, the relatively small size of the plane, the fact that passengers have to buy refreshments on flight, and the free seating arrangement may come as an unexpected (and unwanted) surprise to many.
The tag line “Simplifly” is a smart line that encapsulates “simplicity” in the context of flying, but many miss the subtlety of the line and read it as “Simplify,” which is not entirely bad in itself. However, Deccan’s advertisements focus almost exclusively on announcing new flights and rates, an opportunity that might be better used to explain aspects such as how the airline keeps its costs low. Communicating about the cost cutting techniques of, for instance, paper print outs in place of conventional flight tickets or the lack of free snacks on the flight, could be a useful to prepare the traveler for the flight experience. In the absence of an explanation of the brand’s strategy, Deccan stands to look cheap rather than inexpensive.
In practice, customer care varies from good to mediocre at Deccan. Service inconsistencies and aggressive call centre personnel lead to a feeling of “you get what you pay for,” an aspect that lacks the tactical brilliance of pricing and good cheer that Southwest radiates.
At present, limited routes and limited service restrict the brand from attracting a lot of travelers with its low cost offering. As these limitations fade, how well the brand capitalizes on its good start, how well it manages growth, and how well it survives competition remains to be seen. But for now the brand has a lot to do to convert its ambitious start into a success story.
3. Financial Status – Air Deccan
The Indian aviation sector is forecast to grow 20% a year over the next five years, as budget carriers draw in rail passengers in a country where less than a percentage of the billion-plus people travel by air each year. Air Deccan has an equity capital of only Rs 30 crore (Rs 300 million) and a debt component of Rs 15 crore (Rs 150 million). Air Deccan will seek to reach a larger audience in its maiden foray into the capital markets by floating 33-35% of its stock. The Air Deccan IPO, likely between November ‘05 and June ‘06, may see unloading of an estimated 17-19m shares in the market. The airline expects the IPO to raise an estimated $300m. The two investors, ICICI and International Capital, which hold around 26% in the company with their $40m private equity placement in January ‘05, may reduce their exposure to half during the IPO. The promoters, led by its MD GR Gopinath, may divest 20% or more of their equity. The IPO will not only provide an avenue to investors to part-unlock the value of their investment, but will also help in better retention of employees holding stock under the ESOP. Air mentioned that it will be in keeping with the airline’s buoyant growth prospects. The airline, which carried just under a million passengers last fiscal clocked revenues of Rs 350-370 crore with a marginal profit.
The topline is expected to touch Rs 1,000 crore this fiscal on the back of multifold increase in profit over last year, and a targeted passenger carriage of four million. The airline proposes to ramp up its fleet strength from 18 planes now (including five Airbus 320s) to 27-28 planes by March 31, ‘06. Deliveries of its 62 planes (32 A320s and 30 ATR-500-42/72 series) which were ordered for in December-January ‘05, will also commence shortly.
The airline keeps costs in check by offering tickets through the Internet. They will definitely be in a profit — (but) it will be a marginal profit because of the uncertainty on oil prices. The IPO is for fleet acquisition and enhancing our engineering and operational capabilities. Fuel accounts for about a third of Air Deccan’s ticket prices. Air Deccan competes with larger players like Jet Airways, state-run Indian Airlines and privately-held Air Sahara as well as another budget carrier, Kingfisher Airlines, run by United Breweries.
Air Deccan carried 11 lakh passengers last year while Jet ferried 79 lakh and IA carried 76 lakh travellers. Mr Gopinath said up to 40% of Air Deccan’s passengers were flying by air for the first time. Earlier this year, Jet Airways made a sterling debut on the stock markets after its $435m stock offering was heavily over-subscribed.
The airline is also considering an issue of American Depository Receipts (ADR). Plans for the offering, expected in June next year, come on the heels of a hugely successful issue launched by Jet Airways last year. The company has bought a group insurance policy of $200 million in the case of an air crash. As per the policy, passengers will be entitled to a minimum cover of Rs 750,000 each.
Air-Deccan could take up to 20% of the market if it is able to sustain operations for the next few years.
4. UNIQUE BUYING PROPOSITION
What's an Air Deccan flight can give to customers?
For starters, it's cheap. It is fast. And it is safe.
Customers can also book their ticket, which is priced at just a little more than half the cost of a regular airline ticket, on the Internet. There are no sweets or cotton earplugs when you take off. Then there are efficient airhostesses who wheel around carts of food: only, customers have to pay for the food.
All that passengers want from this airline is punctuality and safety, so Air Deccan takes extra care to ensure these two.
Government regulations prescribe that an insurance of Rs 7.5 lakh (Rs 750,000) should be taken out on every passenger who travels on the airline. However, Air Deccan makes a combined single insurance of $200 million on every flight and all the passengers who travel on it.
To book an e-ticket, customers have to log into their Web site www.airdeccan.net. Customers are taken, step-by-step, through a six-stage booking procedure, which even helps them to decide what flight they want to take.
Custoemrs can search for a suitable flight right on the Net, find out whether seats are available and get ticket prices (including taxes) online. Then, they have the option of contacting a mobile phone number and blocking a ticket, or filling up a form online and buying the ticket, using your credit card. There is a transaction fee of Rs 25 on every ticket.
Air Deccan does not provide the luxury of a coach to transport customers to their aircraft. Customers have to walk across the tarmac towards it.
Once any customer reach the aircraft, he/she will be treated as well as a passenger on any other more expensive airline. The passengers who are flying with Air Deccan right now are doing so for a variety of reasons.
To reach the destination quickly, and they don’t care about being served good food or drink.
To encourage a local enterprise.
First time fliers who are just to enjoy the travel by flight.
This airlines is not really low-budget, it is just regional. Their major USP (unique selling proposition) is extremely low airfares.
5. COMPETITION
Air Deccan can claim credit for bringing the budget airline concept to the Indian skies. Started last year, the Bangalore-based company is a subsidiary of Deccan Aviation, which operates chartered air services, mainly with helicopters. Air Deccan unleashed cut-throat competition in the aviation scene with fares mostly equalling similar train fares. In response, leading domestic airlines like Indian Airlines, Jet Air and Sahara Airlines slashed rates and unveiled Advanced Purchase schemes (Apex) to take on the new challenger. Competition, as always, brought the best to the customer. “Our mission is to keep our fares low and keep lowering them with time,” says Air Deccan’s Gopinath. Air Deccan is initially planning to tap the budget air traveler to and from metros to non-metros. But competition was not far behind. Barely a year after Air Deccan took to the skies comes news of Vijay Mallya’s Kingfisher Airline. In June this year, Mallya announced his plans to take to the skies with his own Indian no-friller. The flamboyant chairman of the multi-crore UB group is not known to do things half-way. And Mallya will be flying on the wings of the well-established Kingfisher brand. Bangalore’s King of Good Times, a trained pilot himself, went the whole hog with plans for a 16-strong Airbus A-320 fleet to run its operations. (Four have been ordered from Airbus, with options to buy eight more, and operating another four on lease basis.) "It is always good to welcome a new customer to the Airbus family, and we derive great satisfaction in being its partner in delivering comfort and value to passengers," says Airbus President and CEO Noël Forgeard. Kingfisher is investing Rs 150 crore to kick off operations. Expect a dazzling show. Mallya’s birds will be taking to the skies in early 2005. Here’s a sneak preview: Kingfisher Airlines, Mallya says, will not be a run-of-the mill Indian budget airline. Expect a value-added designer no-friller. Kingfisher Airlines will be emphasizing on spunky, well-done interiors and trained airhostesses. Each A-320 will carry 180 passengers. Borrowing from the Kingfisher beer tagline of “The King of Good Times”, Mallya is pushing the theme of “Fly The Good Times” for his unborn baby. Kingfisher is planning to capture the Indian budget airline market with the twin engines of ‘special flying experience’ and ‘value for money’. Contests like `Kingfisher flying face of the month' are on cards.
The Kingfisher air hostesses will be selected through a nationwide contest. Expect designer staff uniforms. The Kingfisher "Funliners" will have in-flight silent auctions for lifestyle products and sales of packaged food and beverages. Mallya is sure to leverage on the Kingfisher brand of exuberant, youthful and fast-paced image. The man behind the Kingfisher swimsuit calendar can be expected to put up a stiff challenge to Air Deccan and other low-cost aspirants. To begin with, Kingfisher Airline has roped in model Katrina Kaif to endorse the airline. We hope you get it. Don’t expect an Udipi hotel from Mallya. Await the smart fast food joint.
Vijay Mallya already has a company called UB Air, which is a non-scheduled airline. He will be probably moving the civil aviation authorities to convert this licence to one for a scheduled airline. Kingfisher Airline charges are expected to be higher than Air Deccan’s, but substantially less than those of the big players. Even as the budget carrier battle hots up, the airline biggies are not sitting idle. Country’s flag carrier Air-India recently announced its move to set up a subsidiary called Air India Express, which will be an international low-cost airline. Air India Express will be taking to skies in March 2005. There will be a fleet of 14 Boeing 737-800s, which will be taken on dry lease in three phases. These aircraft will have 181 Economy Class seats in single class configuration. The new airline will operate 63 flights per week when six aircraft are inducted on dry lease at the time of the launch. With the induction of four more aircraft, effective winter 2005, Air India Express will operate 38 additional flights, and add another 26 flights in the third phase effective April 2006, when four more aircraft will join the fleet. Thus, within a year of operations, Air-India Express will operate a total of 127 flights with 14 aircraft to destinations in the Gulf and South-east Asia. Meanwhile, Australian carrier Qantas Airways is planning to include Indian cities among many others for its low-cost airline to be launched in November this year. The as-yet-unnamed airline will be operated from Singapore, says Qantas Airways manager (India & South Asia) Khursheed Lam. The inclusion of Indian cities for Qantas low-cost low-cost airline is subject to bilateral seat sharing agreement and code-sharing, according to Ms Lam. Bilateral discussions over seats and code-sharing between the two countries are likely to be held next week. "We have a flexible approach as far as flights, destinations in India and code sharing are concerned,” Qantas Airways, head of sales & distribution, Rob Gurney said. The planned Qantas budget airline is a move to participate in the booming intra-Asia travel mart. The no-frill airline is set to commence with four A320 aircraft in November out of the eight A320 aircraft, for which lease agreements have been signed. The airline has plans to build a fleet of more than 20 aircrafts over the next three years. The ambitious plans notwithstanding, the history of private sector aviation in India is not very heartening. Ratan Tata is still sore that the Air India nationalisation left the Tata group high and dry. Tata’s late attempts to bid in the botched Air India privatization process came a cropper. Air India divestment plan itself was abandoned. Earlier, Indian private airline operators like NEPC Airlines and East West Airlines disappeared without a trace. Every few weeks, leading private carrier Jet Airways is faced without questions about its funding and promoters. It was Arun Shourie himself who said when he was divestment minister that he doesn’t know if Jet Air is an Indian or a foreign firm! Meanwhile, another low-cost Indian carrier is reportedly facing problems in starting up. The Bangalore-based AirOne Feeder Airline, was supposed to start its flights with two Embraers from Brazil. The delay in Embraer delivery has forced AirOne Feeder to postpone its launch twice already. AirOne is now expected to take off only in early 2005. The company is looking at leasing two new Embraers with 50-seat capacity. The Embraer brand is not generally used in India. AirOne is believed to be targeting non-metro routes to corner its share of the market.
As the catfight hots up, expect fur to fly. Air Deccan says its aim to keep reducing fares further and further. More carriers, both Indian and foreign are expected to come up. Airline industry experts believe that there is space for at least five domestic low-cost airlines in India. Meanwhile, expect the big daddies of domestic aviation to match up with cost-cutting and aggressive Apex schemes. The battle for budget skies has just begun.
Given that the exceptional growth in the past two years have been driven by falling airfares, it’s the low-cost airlines that will likely draw a larger percentage of the new non-business travellers. And fares can still go lower. Says Subhash Goyal, president, Indian Tour Operators Association: "Fares can fall 25 per cent from current levels." This could happen as early as later this year, when more low-cost airlines launch their services. If fares fall by 25 per cent and Jet follows suit, as it will probably have to in cost-conscious India, the airline will have to ferry 30 per cent more passengers in 2005-06 just to match its 2004-05 revenues. Only after that will growth kick in.
Unless oil prices go up further, full-service airlines can forget about higher fares in the foreseeable future. Their growth will primarily come from flying more passengers. Last year, Jet’s average aircraft occupancy was around 65 per cent. Traffic in India is projected to increase at 5-6 per cent a year for the next 10 years. By comparison, the industry is expected to increase seats by 20 per cent this year. In other words, it will take some years for occupancy to catch up. Foreign routes, which were recently opened to Jet and Sahara on a selective basis, will be a new revenue stream, but these are also cut-throat markets.
Luxury rail segment faces air challenge
With air fares hitting rock-bottom, it is the railways that has been most hit. Therefore, it is imperative for the railways to take on competition head-on. The decision of more airlines like the Deccan Airways to jump into the cut fare market for long distance travel is undoubtedly coming as a bolt out of the blue for the railways which is getting more immersed into social moorings than concentrating on profit making ways. The plethora of incentives from the airlines is, however, making the railways now sit-up for fear of losing the upmarket luxury segment which provides higher profitability than the second class sector.
Even otherwise, the new challenges have made modernisation of the railways imperative. Railway minister Lalu Prasad, who had strongly advocated against privatisation saying he would not even hesitate to resign in case it is forced on his ministry, seems to be tempering his pronouncements by admitting that the Rakesh Mohan committee and other reports for making railways competitive are relevant. The various recommendations, among other things, have called for commer-cialisation of vacant rail land and offering offseason discounts in the air-conditioned class.
Railways have about 423,000 hectares (ha) of land out of which 20,000 ha of land is vacant, mostly in longitudinal strips along the track. Even though much of the land is required by Railway for its own use, the earlier proposal for commercialising the air space in these lands has not gained momentum. Currently, in a small way, the land which is not needed for immediate use is utilised temporarily for plantation, commercial licensing, for purposes directly connected with Railway working, etc.
Railway officials, however, claim that the various programmes including technology upgradation to make the sector commercially viable is receiving utmost attention. As a follow up to the Independence Day pronouncement of former prime minister Atal Bihari Vajpayee last year regarding setting up of a Technology Mission on Railway Safety, they say action has been initiated and four mission programmes in the field of traction and rolling stock, track and bridges, signal and communications and fog vision instrumentation have been jointly identified by RDSO and IIT-Kanpur. Ministry of railways has approved 14 projects under the four mission programmes and it will be a joint effort between ministry of railways, ministry of human resource development and industry.
Though the railways is trying to keep pace with technology infusion and other modernisation measures to remain competitive, these would have to be greatly enhanced at a shorter period of time. For instance, the speedy internet airline ticketing system would have to be strongly matched with a people friendly online booking system in the railways.
It is in the fitness of things that the frontiers of the much acclaimed customer friendly computerised passenger reservation system (PRS) have been expanded further with the introduction of internet booking. Now, reserved tickets are also being delivered at the doorstep of the customer. On the unreserved side, where difficulties continued to persist, a major break-through was achieved last year with the introduction of computerised Unreserved ticketing system (UTS), which seems to be finding acceptance among the general public. Officials state that the system is proposed to be extended further.
In the new era of transport alternatives, the railways would need to overhaul its system, both for freight and the passenger services, to stay afloat as a commercially feasible and profitable organisation.
6. Operating Strategy
Are the operators going to slash the fares for the executive class as well so that he can shift into the Everybody has a worry or query as far as India's civil aviation sector is concerned. But the fact remains that history has been created in the country with the cost of air travel coming to as low as Rs.700. While Air Deccan has set the ball rolling in the skies with its most affordable airline, Delhi-Mumbai for Rs.700, it is set to face stiff competition even at this down-to-earth rate, not to mention surviving the logistics that are at odds. The moot point, however, remains - is the concept viable in India? Those who have a stake in it believe it can be achieved by cutting out frills.
Startups in the runway
Perhaps even J R D Tata, the man who brought aviation into this country, might not have visualised such a future when train and air travel will be at par by default. But it has become a reality, at least for the time being. Air passengers in India may soon reap the benefits of cheaper fares with several players planning to start low-cost airlines. Already, as many as 12 startups have applied for licences. This is when the civil aviation minister Praful Patel has stated in Parliament that there is no proposal at present to open up the domestic aviation sector to foreign airlines. Otherwise, the queue would be even bigger.
Liquor baron Vijay Mallya of the UB group, known for his beer brand, Kingfisher, already owns a fleet of helicopters and private jets, is also set to launch Kingfisher Air, his version of cheap airline. The Wadia group, owned by Bombay Dyeing chief Nusli Wadia, is also planning to foray into the low-cost airlines business. The Wadias have already applied for the necessary permission from the civil aviation ministry and are hoping to commence service early next year.
Even our national carrier does not want to be left behind in this rat race: Alliance Air, the Indian Airlines subsidiary which operates Boeing 737s, will become the national carrier's low cost airline. Not only this, in order to take the battle a bit further, India's international flag carrier, Air-India is planning to launch a new discount airline - Air-India Express - by April 2005. The move is aimed at boosting the share of Air-India in the Gulf and Southeast Asian markets. These markets have been the most profitable for the airline but it has been facing stiff competition on these routes. The new discount airline will have about 25 per cent lower fares than the ones offered by other international airlines.
As low as it can get
So just how cheap is it going to get? Air Deccan, the company which pioneered no-frills flying, says a Delhi-Mumbai ticket could be bought for as low as Rs.500 - only Rs.20 more than a second-class rail journey. The business philosophy of Capt G R Gopinath, managing director, Air Deccan, is loud and clear - the next time you will have one guy paying Rs.500, another guy paying Rs.4500 and the guy next to you Rs.3000, all in the same flight! Such fares would be possible because the airline will auction away its seats - about 180 seats on the Delhi-Mumbai flight - on a first-come-first-served basis.
If a passenger decides to buy a ticket three months before the journey, the ticket comes for only Rs.500. The same ticket will cost Rs.4500 if you buy it a day before your journey.
At present, only 1.5 per cent of Indians can fly given the high airfare but all that could change with the entry of low-cost operators into the market. Air travel became much more affordable when the airline companies announced Apex fares. People could travel at half the cost by simply buying a ticket 30 days in advance. Now if the low-cost airlines succeed, it could well change the rules of flying in India.
Let's accept that the demand factor promises a smooth ride for the low-cost airlines. The most affordable means of travelling in the country, railway, is in such a miserable state that nobody wants to travel by rail, only if one can help it. Concerns are many - from safety to poor quality of service, overcrowded coaches to booking problems.
Packaging is the mantra
Here it would be pertinent to understand as to who would fly these low-cost airlines in India. Keeping in mind the business model of these airlines, where bookings have to be made at least 30 days in advance, there seem to be three segments of customers - the price conscious business traveller, the leisure traveller and those who planned vacation much in advance. Now, if we talk of business travellers, a large proportion of them travel at company expense and might not have a reason to migrate from full-service airlines. The fact that most of the business meetings are not planned that much in advance is also a deterrent. And in order to tap the other two segments of air travellers, the LCAs need to tie up with the travel agents to offer the tour packages. This is a model practice worldwide, like Air Asia's tour packages from Bangkok to Penang, or a honeymoon package from Kuala Lumpur to Phuket. But the very business model of the Indian LCAs is dismissive of travel agents in order to cut the cost. As a result, many enthusiastic travellers will never come to understand that low cost air travel is simple, easy to book and a great savings option.
The grey areas
Air Deccan is already facing rough weather on the route. The airline has not yet managed to get a counter at the Delhi airport to sell tickets. Most low-cost airlines want to start their flights from metros like Delhi and Mumbai. But airport officials say they have a problem in hand as infrastructure at these airports seems over- stretched. Delhi and Mumbai airports handle 20,000 domestic passengers a day and more passengers will only lead to more congestion. There are no extra parking bays in both the airports and the new airlines may have to park their planes in nearby airports. This means their fuel costs will go up.
This is just the tip of the iceberg. In a country where the domestic aviation sector has been repeatedly complaining how difficult it is to sustain, survival logistics seem to be heavily placed. In reply to a question early this year, Parliament was told that while losses of Indian Airlines had been Rs.145 crore in 2002-03, India's largest private airline Jet lost Rs.242 crore in the same year.
Experts believe the government must ensure measures to check the high cost of infrastructure. While the landing charges at Indian airports are too high compared to international norms, state governments impose hefty taxes on aviation turbine fuel.
At what cost?
But the question still stands - cost cutting at what cost? And how much will it save? Obviously, no frills on board means lesser crew staff, which can cut the cost up to 10 per cent. Secondly, by selling the tickets through the Internet, which can also save the commission of travel agent, there can be, a saving of another 10 per cent. Then selling food and drinks on board can increase revenue. Besides, this airlines is also planning to advertise on seats and boarding passes.
7. WILL AIR DECCAN SURVIVE?
It's an audacious incentive scheme -- especially in the glamourous world of the airline business. The next time customers may find an airhostess on board the no-frills airline Air Deccan cajoling customers into buying samosas, a sandwich, or even bottled water, don't be taken aback.
For the airline offers its cabin crew a 10 per cent commission on all beverages and food that they sell passengers on the flight. Captain G R Gopinath, co-promoter and managing director of Air Deccan, explains the logic.
As the airline does not offer complimentary meals, he expects the average passenger to fork out about Rs 75 to pick up a quick meal. On a margin of 30 per cent for the 1 million passengers who have flown Air Deccan over the last 12 months, that means Rs 7.5 crore (Rs 75 million) in extra revenue.
That, of course, is not the only way Air Deccan is innovating revenue. It hawks advertisement space on the seats, the cabin interiors, and even on the body of the airplane.
And it will soon offer inflight entertainment -- from movies to news and music -- at a cost, naturally. Gopinath reels off some figures -- the airline is already making about Rs 20 lakh (Rs 2 million) on each Airbus aircraft a month through ad revenue, and he hopes to squeeze in another Rs 5 crore (Rs 50 million) by hawking inflight entertainment.
These permutations aside, what is Gopinath's secret mantra for running a low-cost airline? "My cost per kilometre per seat is only 4.3 cents," he says simply, "my competitors fly at 8-16 cents. My revenue yield is 5.1 cents. And now, by expanding the network and adding more flights, I will reduce costs even further".
That is precisely what Gopinath and his team are busy with: Air Deccan is on a major overdrive and wants to transform itself from a small regional feeder route carrier to a pan-Indian player.
Taking off rather shakily (its inaugural flight had caught fire) with only two ATR turbo-prop aircraft in September 2003, the fledging airline has targeted a fleet of over 35 aircraft by March 2006 (which will include 13 Airbus 320s).
At the moment it flies 64 flights a day, with 7 ATRs and three Airbuses, but has set itself an ambitious five-fold increase in the number of flights to about 300 by March 2006.
That's not all. By March 2005, the airline hopes to grab a 10 per cent market share (up from 3 per cent in March 2003) with a passenger load of 1.4 million. It will add 10 new cities on the map within the next four months. The target is to have over 30 Airbuses and a similar number of ATR turbo-props in the next three years.
The cornerstone of the aggressive expansion is rock-bottom tariffs to impel users of railways to upgrade to air travel. The first salvo was shot last year when Air Deccan offered tariffs that were at least 50 per cent cheaper than scheduled airlines.
But the bigger bombshell was thrown this year when Air Deccan offered air travel at an amazing Rs 700 (on only a few seats) -- virtually half the price of a railway ticket in many destinations. By next year the airline hopes to push down tariffs by at least another 10-20 per cent.
And Gopinath is not complaining. Already, as much as 90 per cent of the 10,000 seats till March 2005 on the Bangalore-Mumbai sector are booked. On the Delhi-Mumbai sector, 65 per cent of the capacity for the same period is full. But the pygmy airline is still thirsting for dollops of cash if it is to fly into the big league.
Industry watchers say the going had been easy so far as Air Deccan mostly leased turbo-prop ATRs. But the game will change dramatically with the introduction of Airbuses and forays into metro routes where Indian Airlines and Jet Airways reign supreme.
Inevitably, this had led to speculation about Air Deccan's survival. Already, the company has slipped from its turnover target of $120 million by March 2005 because of delay in aircraft acquisition, scaling it down to $90 million.
Nor will the going be easy. Says Kapil Kaul, senior vice president of the Centre for Asia Pacific Aviation, an aviation consultancy firm, "Air Deccan will have to face intense competition from new airlines like Wadia, Kingfisher Air and Royal Air next year, all of which are looking at low-cost models. Also, the existing carriers will not keep quiet."
The three big carriers, for instance, have been quick in responding to the Air Deccan challenge on metro routes by dropping tariffs on select flights where, unlike an apex fare, you need not book earlier.
Indian Airlines has responded by bringing down tariffs on its flights that coincide with those of Air Deccan. For instance, IA is offering Fly Select fares on three flights from Delhi to Mumbai -- at 9 am, 10 am and 6 pm -- for Rs 4,200. (Air Deccan flies at 8.55 am and 4.30 pm.) Says an IA executive: "Passengers may pay Rs 500-1,000 more, but they get major advantages -- they don't have to book in advance or lose their money if they cancel, and will get food and beverage on the flight. The premium they pay is very little".
Even Jet (through their Check Fares) and Air Sahara (through Steal a Seat) are using the same model. IA is also planning to have at least three of its Airbus 319s, which will be delivered next year to run with only economy seats and cheaper tariffs.
Competitors point out that the average tariffs for Air Deccan aren't as low as they are made out to be, and even Air Deccan admits to an average ticket yield of Rs 3,750 on its Bangalore -Delhi leg.
The hyped Rs 700 seat is booked within hours, and for many passengers seems more an advertising gimmick than reality. In most cases, the apex fares offered by the three airlines are more or less similar to what you can book on Air Deccan.
Says a senior executive of a competing airline: "If you book three months in advance, you get a cheap price, but between the seven-30 day advance booking period there are many cases where tariffs of full carriers are cheaper".
Also, these carriers are cutting costs too. Says Rono Dutta, CEO of Air Sahara: "There are smarter ways of cutting costs than by stripping down the product. In fact, today our costs are not any higher than those of Air Deccan."
Sahara has restructured its routes by creating a hub in Hyderabad. Dutta says this will improve utilisation of his fleet by over 10 per cent and save passengers travel time of over 50 per cent for those taking onward flights, as they don't have to wait long to take the next flight.
Plus, with the carrier spending $20 million, it will save cost by having a single hub, spare parts depot and maintenance centre for its whole operation.
So where have Gopinath and his men cut costs? Gopinath suggests that his Airbus aircraft have 180 seats -- 22 per cent more than what his competitors squeeze in -- and that he flies his aircraft for over 12 hours compared to the competition's eight-nine hours.
Besides, his sales and distribution costs constitute only 8 per cent of the total cost compared to the full-service airlines that spend as much as 28 per cent.
That's because he has managed to shift bookings away from travel agents to the Net, ensuring his money upfront (you pay by credit card or cash), does not use international reservation systems (like Amadeus), which charge money for each transaction, and saves on agency commission.
There are also savings in avoiding the printing of tickets, and keeping staff on a tight leash. Besides, he only flies point to point with no onwards or connecting flights, saving on both fuel and time.
But many analysts and competitors say the cost-cutting model might not work here at all. For instance, IA says it also flies its aircraft for 11 hours, so that's not a big deal.
Adds Sahara's Dutta: "Low-cost made sense in Europe and US where labour costs constituted over 45 per cent of total cost; in India it is not more than 15 per cent. Instead, 50 per cent of the cost is fixed."
Analysts suggest that Air Deccan's ATRs did not have to pay landing fees, and forked out nominal navigation charges (government allows special rates for aircraft with less than 50 seats).
"But with Airbus, this saving (which is as high as 18 per cent of total cost) will cease to exist. Then the battle will be different." Worse, unlike in Europe, there are no no-frills airports (such as Gatwick in UK) that charge a fraction of the cost for landing and parking compared to the main airport.
Competitors also point out that the key ingredient for success of a low-cost airline is its dependance on e-ticketing. But in the case of Air Deccan, as much as 40 per cent ticket sales are through agents.
Says an airline executive: "He offers them the same 5 per cent commission we do, and is now also offering them credit lines. If they were not important, why should he do so?"
For instance, Air Deccan has recently tied up with ICICI Bank under which agents are issued a special Air Deccan credit card to buy tickets from the Net with a 40-day credit free limit. (Gopinath says he still gets his money upfront from the bank.)
The managing director of Air Deccan knows it isn't going to be a cakewalk for him. But he points out that he should be able to make a profit in the first year of operation itself.
No doubt he is also banking heavily on how successfully he can raise the funds for his next expansion phase. That could well be his acid test. And he knows the battle will only get fiercer.
Money matters
Air Deccan has an equity capital of only Rs 30 crore (Rs 300 million) and a debt component of Rs 15 crore (Rs 150 million). That might be passable when you run a small operation with turbo props, but running a pan Indian airline with Airbuses is a different kettle of fish.
Company finance director Mohan Kumar agrees that the funding requirement will change dramatically -- he is scouting for $300 million to buy six Airbus aircraft next year -- by roping in fresh investors to expand the equity capital base.
Already, Air Deccan is in the final stage of negotiations with three equity investors (ICICI Venture and Capital One among them) to raise $50-60 in fresh equity.
Says Kumar: "We might do a deal with all three, or with one of them. An option is to issue zero-interest convertible debentures to these investors where the conversion would be tied up with the company's performance." The company is ready to offer up to 26 per cent to the new investors.
That still leaves a yawning gap of $240 million. Air Deccan says this will be raised through debt, talks for which are on with Export Credit Agency of Europe that funds up to 85 per cent of the cost of the plane as long as companies buy European products.
But that could overburden the company with debt and high interest costs. Kumar says the debt to equity ratio will go up from 0.5 to 2 -- beyond this would put a strain on the company's bottomline.
So on an equity capital base of $67 million (after the new investors have been roped in) it will be able to raise debt to a maximum of another $130 million.
That still leaves a gap. Kumar's answer is to get into a contract with Airbus to buy the aircraft (as the Export Credit Agency does not give loans for leasing out), then transfer the contract to a bank or a leasing company which will then buy the aircraft and lease it back to Air Deccan.
Talks are already on with international banks, he says, that will ensure Air Deccan's debt burden is under control. He says the company might be able to buy two aircraft (the price of an Airbus 320 is around $56 million) and take the rest on lease.
Analysts say the airline's future is uncertain until the financial deals are closed. Especially as the financial restructuring does not include the leasing of more ATRs.
They also say the debt burden could put tremendous pressure on the company's bottomline, something Kumar refutes as he says that these are long term loans spread throughout the life of the air craft.
8. FUTURE OF THE INDUSTRY
India Inc is going places, literally. With the civil aviation and tourism portfolios at the Centre under the charge of able ministers like Praful Patel and Renuka Chowdhary - combined with a leadership inclined to open up the economy, one suddenly witnesses great dynamism in these sectors. The country is witnessing an unprecedented revolution in the aviation industry that is opening the skies to private carriers, driving down ticket prices and giving foreign airlines and equipment suppliers unmatched access to one of the world's fastest-growing markets. But how long will this boom sustain? Express Travel & Tourism takes a look at both sides of the coin - the good and the bad of the sudden aviation boom.
Picture Perfect: Aviation Boom
The explosion in Indian air travel is driven by a booming economy, a rapidly growing middle class and increased deregulation. Not a week passes without one airline or another coming out with announcements on introducing new routes or expanding services on existing routes. The liberalised policy has also been permitting airline companies in India to expand operations both within and outside the country.
Air Traffic Booming
Despite the nation's population of more than a billion people, it has just 165 commercial planes. The United States, which has about 300 million people, has about 6,000 commercial airliners. But India is changing rapidly, emerging as one of the fastest-growing markets. Air traffic in India has been growing rapidly, adding around 275,000 passenger seats in 2004, and it is expected to add more than 325,000 in 2005. Even aircraft manufacturers are working out their strategies for India and to that effect, Boeing itself has revised its projections upward. Barely six months ago, it projected its business in India would reach US$ 20 billion within 20 years. Now, the company is saying it will grow to US$ 35 billion in that time.
Route Expansion
After a gap of nearly 15 years, one witnesses tremendous activity at state-owned Air-India and Indian Airlines. Inept and poor political leadership, lack of resources and the absence of new policy initiatives have bedeviled these airlines. All these seem to have been pushed back in the last couple of years. Both companies have been busy planning major fleet expansions. Boldly going for lease options, these state-owned airlines are preparing themselves to win a good stake of the present boom in air travel. Air-India posed impressive plans for its no-frill subsidiary, Air-India Express that offers attractive introductory fares to countries in the Gulf from Delhi, Mumbai and Kerala.
Recently, Britain and India agreed to more than double air flights on existing routes between the two nations and open up lucrative new services to Indian cities. A similar deal was signed between India and the US. Jet Airways, India's largest domestic carrier, announced that passenger traffic would increase by 15-18 per cent this year.
The boom in the Indian aviation industry has boosted the fortunes of international aircraft leasing companies, whose business in India has tripled over the last two years. Almost every airline, public or private, is taking the lease route to raise capacity in the shortest possible time. Benefits of operating leases include lower cash outlays to preserve working capital, the flexibility to increase or reduce capacity quickly and the ability to induct new aircraft models with no need for pre-delivery payments.
Lufthansa, is the perfect example for being the most successful in capturing emerging opportunities. Bangalore and Hyderabad in the South have been receiving a lot more attention well before the new airports in these cities have taken shape. Lufthansa and Saudi Arabian Airlines have introduced new flights from Hyderabad. Asian, European and Middle Eastern airlines are already ramping up flights to India. Britain's Virgin Atlantic Group even hopes to buy a stake in an Indian carrier, although civil aviation authorities have yet to permit such investments.
New Carriers…New Options
With more competitors flocking to the India market, prices of tickets for domestic and international travel are plummeting. As Air Deccan has upped the ante with a Re 1 flying offer, Kingfisher Airlines, that has started services on the Mumbai-Bangalore route recently, is talking of becoming the number one domestic airline by 2010. With the announcement of the UB Group's foray in the Indian aviation industry, Kingfisher Airlines has already become a force to reckon with. After Kingfisher Airlines, the rank of budget airlines will have other new entrants like Magic Air and SpiceJet that have already commenced service in May and took the industry by surprise with its Red Hot Rs 99 offer, Go Air and Air One in the coming months. Last but not the least is the re-launch of East West Airline, after almost a decade. The Airline hopes to take wings again by the end of this year and is in the process of renewing its license soon. It is in talks with Boeing and Airbus for buying aircraft, and with two foreign investors to raise US$ 50 million to US$ 60 million in the next two years. Further, according to the Centre for Asia Pacific Aviation, the new low-cost airlines will help add at least five million new passengers every year taking the total number of air travellers to 50 million by 2010.
Open Skies - The After-Effects
One of the arguments for the open skies policy is that it will lead to huge benefits for tourism. A November 30, 2003 government-appointed committee report titled 'A Roadmap For The Civil Aviation Sector' unequivocally states: 'The international air transport segment is inexorably moving towards liberalisation, particularly at the regional and sub-regional levels. Even within bilaterals, which continue to be a dominant form of regulating international air transport, many of the recent agreements and amendments are reported to contain some features of liberalisation. Many countries have unilaterally opted for liberal air transport policies, often based on a broader perspective of national interest, including economic development and trade benefits.'
If Asia's fourth-largest economy is poised to grow significantly over the next five years then even the most conservative analysts predict massive growth in India's air travel market. India, and the wider Asian air travel market represent an opportunity that most airlines are grasping with both hands. Competition will be intense, with new domestic airlines pitching in.
The Challenges Ahead
The aviation ministry, which till very recently was henpecked by the industry for its obdurate stance on deregulation, is now receiving shouts of support for not going too fast too soon. Aviation experts forecast that India's annual passenger load will hit 50 million by 2010. International travel to and from India is soaring at a 20 per cent annual clip. According to the International Air Transport Association (IATA), international airline passenger numbers are set to grow by six per cent year-on-year till 2008. The key driver for the growth would be the economic expansion in India and China. Cargo volume is also likely to be up by six per cent annually over the 2004-08 period. The growth, however, will strain airports and other infrastructure. Though some changes in the management of airport infrastructure have been initiated, India still has a long way to go.
Airport Apathy
Liberalisation and restructuring of airport infrastructure is going to be a far more complex and difficult task than the restructuring of air services. Nearly every aspect of services, from runway maintenance to air-traffic control and baggage handing, needs huge upgrades to cope with bigger demand. The government has earmarked US$ 3 billion to upgrade main gateway airports at Mumbai and New Delhi, and as much as US$ 300 million to build airports at Bangalore and Hyderabad.
V Thulasidas, chairman and managing director, Air-India, takes first guard, "An increase in the international airline seat capacity to and from India is no doubt good for the promotion of tourism. However, this is only one of the facilities required and unless it is supported by other infrastructure facilities like adequate number of hotel rooms, good airports, tourist friendly procedures, good roads and rail connectivity, overall cleanliness etc. An increase in the number of airline seats alone cannot lead to more tourist travel." Therefore, the immediate need of the hour is not so much to start new airlines so much as to develop the airports infrastructure.
He further points out that many of the competing airlines are more interested in exploiting the Indian travel market and not necessarily promoting international tourist travels into India. "What we need is a carefully orchestrated and balanced plan for opening up the international travel sector with adequate emphasis on the growth plans of Air-India. Allowing more foreign airline capacity into India or alternatively permitting domestic airlines to fly international routes need not be the only solution for increasing the international air travel capacity," he adds.
Tourism Reality Check
Qatar Airways CEO, Akbar Al Baker insists that the open skies policies are key to developing the aviation industry in the country and so too, tourism, since airlines are the chief delivery system of the tourism policy of any country. "There are approximately 30 million Indians staying abroad while only 35 million seats have been allocated through the sale of traffic rights of which 17.5 million are utilised leaving a huge gap in supply of seats even for NRIs and expatriates wanting to visit India. These traffic rights include countries that do not operate into India while additional seats are not being granted on high-density routes," he says.
LCC - Not An Easy Task
The verdict on the birth and subsequent maturity of low cost carriers (LCC) still has its jury out on a limb. While it is quite clear that for air travel in this country to become as commonplace a culture as is the case in the US, LCCs have to thrive and consolidate, their roadmap appears fraught with a despairing ignorance from the government in so much as creating a parallel cost regime that recognises the minimal framework these airlines operate within.
Trade Dilemma
Last but definitely not the least is the hot debate between airline and agents on the commission structures. Globally, the current scenario hotting up where airlines and agents are at loggerhead over the zero commission regime, in many a developing market and India is on the hit list at the moment. While the agents' boycott of Air-India did little to move the airline, a bit of history was created when non-IATA association (ETAA) was invited by TAAI and TAFI on a single platform to institute a united stand against the airlines. Further according to industry sources, the joint committee that was subsequently formed could well usher the formation of a consolidated association of IATA and non-IATA agents. Moving on a current note, the issue has been resolved to a certain extent with the committee that has been formed, resolved to push commission stand for Gulf carriers to July and a freeze on the commission paid for the next four years.
Taking the above-mentioned factors into consideration, the aviation industry is definitely in a confused situation where one good deed…gives rise to not another but many unknown hurdles. Surely exciting times for India all around with great business opportunities. But will it miss the bus is the question?
9. RECOMMENDATIONS
Reduce labour costs
All low cost carriers need to win significant concessions from their workers. Low labour outlays would consist of a mix of reduced wages, more flexible work rules and trimmed benefits including pension.
Simplify flight operations
Low-cost carriers use just a few types of aircraft, a strategy that cuts training and maintenance expenses.
Another way to simplify operations is modifying the hub-and-spoke model, which uses designated headquarter airports for transfers and increase service along heavily travelled routes.
Offer more transparent pricing
The low cost carriers have long had an exotic, almost incomprehensible pricing system. However, these days, with the Internet allowing travellers to shop for the cheapest tickets easily, and low-cost airlines offering uncomplicated set prices, these carriers have to follow suit or risk losing more and more passengers.
Get smart on fuel
With oil near $50 a barrel, airlines must be smarter about how they incorporate its price into their costs. Discount carriers lock in prices on future fuel when the price drops.
Stop chasing market share
Airlines need to be savvier about capacity. At the start of 2004, many planned to add more flights amid signs of an improved economy. When it became clear that demand wasn't as strong as originally forecast, most carriers still wouldn't retrench from their plans for fear of losing out if the market snapped back. Rather than scrambling to add seats in fear of missing out on the party, airlines would do well to take a more cautious approach and focus on efficiency and margins.
From bailouts to government partnership
Although the Indian airline industry was largely deregulated in 1990, plenty of lingering rules and regulations have made it nearly impossible for carriers to be efficient. Many believe that restrictions on foreign ownership and labour laws have kept the industry from innovating. So instead of lobbying for protective measures like bailouts, airlines need to work with government to tackle longer-term projects like building more runways, running airports more efficiently, and reining in labour costs.
A new model for premium pricing
Most of the industry's improvement efforts have focused on whittling down costs. However, boosting revenues also needs to be a priority. After all, people are willing to pay more if they believe they're getting more value, especially to the business traveller including airport lounges and more comfortable seating.
Make positioning
Cutting down cost can never be the strategy to attract customers in the longer run. Any carrier should take care of his positioning in customers mind for longer growth and survival in this cut throat competition.