Still Flying High, But Can the Gulf’s Airlines Keep Growth Aloft?

Tallying the recent spending by Gulf-based airlines yields some staggering numbers. Most recently there were the US$25 billion of orders for aircraft and engines from Boeing and Airbus by Dubai-based Emirates Airlines at this year’s international air shows in the U.K. and Germany, and a similar buying spree by Doha-based Qatar Airways, currently valued at US$35 billion. All that was preceded by Abu Dhabi’s Etihad Airways placing a single order in 2008 for 205 passenger jets for US$34 billion and a subsequent order for engines for US$14 billion

The megadeals are accompanied by other signs of the sector’s robust growth in the region. Emirates and Etihad plan to recruit 60,000 staff over the next 10 years. Regional investments in aircraft maintenance facilities are expected to earn US$5 billion in a decade. New ground facilities are being constructed, including Dubai’s second international airport, which opened in July. Meanwhile, Abu Dhabi’s airport is undergoing a multi-billion dollar expansion and Doha’s new airport is slated to open next year.

What makes all this activity all the more noteworthy is that elsewhere, particularly Europe and the U.S., the airline industry is contracting, hobbled by labor woes, rising costs for jet fuel and price wars. The International Air Transport Association (IATA), the industry trade group, reports that this year, Middle Eastern airlines are outperforming the global industry growth average of 11.7% with a growth average of 18%, and will turn US$100 million of profit.

There are several reasons why Gulf airlines are booming, says Nawal Taneja, professor and chair of the department of aviation at Ohio State University, listing their geographic location; ready capital to fund aviation infrastructure, such as airports; availability of fuel efficient, ultra-long-range aircraft; high passenger service, and relatively low fares. Combined, he predicts, these factors "will enable [the companies] to make the region a global aviation hub."

Yet there is concern about the sustainability of the growth. Gulf governments largely support the local aviation sector and determining the true financial health of carriers is a guessing game for analysts. Regulation has also been an issue and there is no open skies agreement in the region. What’s more, competition is mounting from Asia, while European and North American airline companies lobby their governments for protection from Middle East airlines.

It’s also important to place the Middle Eastern airline business into context. "Only [a few] airlines in the world make money, and the industry as a whole loses billions every year," notes Wharton management professor Peter Cappelli. "Fundamentally, the nature of the industry is the problem: The marginal cost of filling an extra seat is almost nothing, so whenever the carriers have excess capacity, they have fare wars, and they all bleed to death. The only time any of them make any money is in the brief period in which demand is growing faster than capacity. Is there any reason to think that the carriers in the Middle East have somehow cracked this problem by spending more on new planes?"

Gifted Geography

As with its petroleum industry, much of the growth of the region’s airline sector is a gift of geography, not to mention some fateful decisions made years ago, observers say. In the 1980s, due to its location and lack of fuel taxes, the Gulf became a waypoint between Europe and Asia for airline companies that needed to refuel. The region has also benefited from a number of bilateral route agreements — which govern air traffic between nations — with other countries, which are now very tough to acquire.

Dubai was the first to leverage these advantages and begin building up its capacity as an airline hub, as well as launching its own carrier, Emirates. The airline is part of Emirates Group, a state-owned conglomerate that includes a number of aviation and tourism businesses. Launched in 1985 with a leased A300, today Emirates has a fleet of 150 aircraft and flies to 103 destinations in 63 countries. In 10 years, the airline expects its destinations to double.

"The Gulf carriers have always put in the capacity ahead of demand and as demand has caught up, they continue to push the envelope," suggests David Huttner, senior vice president of London-based aviation consultancy Nyras. "Their ability to have an investment horizon well beyond any quarterly earnings call or annual report helps facilitate such a strategy."

Part of that strategy calls for aggressively targeting long-haul routes, flights that are more than six-and-a-half hours. Traditionally, the legacy carriers from the U.S. and Europe have operated these routes. But with escalating costs, they have scaled back their service, while the Gulf carriers began buying big aircraft that can fly those routes. According to research by Andreas Knorr and Alexander Eisenkopf, of the German University of Administrative Sciences, "No major [highly populated area] on the globe is further than 8,000 nautical miles away from [Dubai]. As a result, any two major cities on earth can be connected via Dubai with only one stop."

UBS reports that Middle Eastern airlines now account for 36% of traffic flow to and from Europe, with the Dubai-to-London route the most traveled, accounting for an average 1,141 flights a week last year. The route is a critical piece of business since travelers flying to and from Dubai, rather than using the airport to connect to other flights, deliver more revenue, notes George W. Hamlin, president of Hamlin Transportation Consulting in Fairfax, Va.

It’s also important that the airlines are able to provide premium passenger service at a lower cost than other airlines and capture the spending of high-value passengers while filling their long-haul planes with cargo freight. Etihad, for instance, in the first six months of this year had 3.3 million customers, an 11% gain year on year, and is aiming for seven million passengers by the end of 2010. The airline said its seat occupancy level was 72.5% and that its cargo revenues grew by 59%.

Critical to performances such as Etihad’s, says Taneja of Ohio State, are the cost advantages the Gulf’s airlines enjoy over competitors due to cheaper labor, lack of unions, preferred fuel credit, low taxes, government financial support and deploying newer, more efficient fleets.

Hurdles to Growth

But is the growth as sustainable as the airlines believe it is? "The industry outside the Middle East views this with some suspicion," Hamlin points out. "My understanding is that [the public] can’t see the profit and loss of these airlines, so you can’t make any analytical judgments.… I spent 40 years studying the economics of this business and what I’m seeing doesn’t make sense. I understand the value of the Dubai hub, but when we talk about significant premium traffic, is it the same quantity as London?"

The Gulf is not the only region trying to present itself as a bridge between East and West. One emerging regional hub posing a threat to the Gulf’s plans is Turkey’s Istanbul airport and its carrier, Turkish Airways, especially if a new conflict were to break out in the Middle East. "The long-haul market is always open for competition," notes Sandra Anani, a U.K.-based independent aviation industry analyst.

Huttner of Nyras suggests that to ensure growth, the Gulf carriers may need to focus on different areas of expansion. "While one may continue to pursue the single global megahub, another might be compelled to seek stronger strategic alliances with partners that go beyond traditional code share arrangements as an alternative approach to their long term growth plans."

The growth of the Gulf’s airlines will also be checked by competing carriers, which have sought political and legal action to prevent encroachment into their markets. Air Canada, Germany’s Lufthansa and Air India have been lobbying their governments for protection from the Gulf’s airlines. Air Canada claimed it could be pushed into bankruptcy protection if flights from Dubai were allowed to its native hubs and across the country. Chief among the arguments made by these airlines is that their Gulf competitors’ financial backing puts the carriers outside the Middle East at a disadvantage.

The amount of government support the airlines are believed to receive is an issue generating much debate in the industry. Many analysts outside the Middle East suggest government largesse partly explains how the Gulf’s airlines are able to expand, rather than by the strength of their businesses alone. "Although there is an interesting shift in the balance of power away from Europe toward the massive transit hubs in the Middle East … it is very difficult to understand how Emirates and Etihad could be profitable at their current rate of expansion without some form of government financial support," maintains Shakeel Adam, an airline restructuring consultant with London-based Athena Aviation.

"It is, of course, hard to compete against competitors who are subsidized," Wharton’s Cappelli says. "But the subsidies often come with political control that gets in the way of operating effectiveness, and that’s where for-profit operators have an advantage."

Political control, in the form of restrictive government regulations, is the factor that analysts say contributes to the inefficiency of the Gulf’s aviation industry, and could prevent growth. For example, government interference is blamed for the recent failure of Sama Airlines, a low-budget carrier in Saudi Arabia. Furthermore, there is no open skies agreement between the region’s countries, and few expect any moves forthcoming to liberalize and deregulate the market. Without an open skies agreement, the carriers must pay a number of extra charges to land aircraft in places that are not their native country, and many countries restrict which airlines may offer flights to their airports.

A report by consultants at Booz Allen Hamilton on the Middle Eastern aviation system noted that the growth aspirations of the region’s carriers demand a system that within 20 years will be able to handle four times the number of passengers it serves today. However, according to the report, the system does not even fulfill the demands placed on it currently, falling behind global standards for efficiency and service.

"The home markets of these airlines can’t possibly support the level of expansion announced," says Jay Sorensen, president of IdeaWorks, which develops marketing programs for the travel industry. "Global connecting traffic will be captured at lower fares. Failing this, mergers [between overlapping airlines] will be the only solution. And yes, I do see a bit of ‘Gold Rush fever’ in the multiple announcements regarding network expansion, aircraft orders and concrete being poured for airports."

Three’s a Crowd?

Sorensen cites the concern that many in the industry think is the biggest threat to the growth of airlines in the Gulf — replication, particularly considering Doha, Abu Dhabi and Dubai are within an hour’s flight of each other. "There is an obvious and strategic effort by investors and governments in the Middle East to make the region a global hub," he points out. "Not just one global hub, but many. My concern is all this activity is occurring simultaneously."

Opinion is divided about what lies ahead. Hamlin is of the view that hubs can exist in close geographic proximity to one another, citing London, Paris and Frankfurt’s airports. But the passenger traffic in Europe, particularly premium passengers, is far greater than that in the Gulf, he says. However, Taneja notes that the Gulf’s airlines are positioned to feed into route traffic from markets that others haven’t been able to capture, particularly Africa, and will continue to benefit from the growing economies of India and China.

In a recent interview with the magazine CEO Middle East, British Airways head Willie Walsh suggested that of the three big Gulf carriers, one possibly would not survive, and that the furthest behind in the race to establish a global hub was Abu Dhabi.

Mark Elliot, of Athena Aviation in London, agrees that Qatar has managed to create a reason for having a hub, and he also says that the United Arab Emirates will not sustain two hubs within its borders. "It is arguable that a merger between Etihad and Emirates will have to occur at some point for some form of balance to return to the region," Elliot notes. "But that will not improve anything if all it does is create a behemoth with two deep pockets."

According to Huttner, competition among Gulf airlines could become a problem if it moves their focus away from the business. "There is no question that Emirates had a tremendous head start in this race and that is a tribute to [Dubai's] foresight, but this is not a race of countries," he points out. "More than one carrier can do well in the same region, even if they are in close proximity. Singapore Airlines and Cathay Pacific have coexisted successfully for years. But while they were paying lots of attention to each other, it is not clear that they were fully anticipating the threat that has emerged out of the Gulf in the last decade. In the same light, if the Gulf carriers spend too much time watching each other, they might not notice other emerging threats."

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