Competing for Customers and Capital

Law & Order

“Law & Order” is the most successful TV franchise of all time and one of my favorite shows. If I rewrote the opening voice-over from that series to capture the essence of Competing for Customers and Capital it would read like this:

In the private enterprise system, investors are informed by two separate yet equally important groups -- customer markets where revenue is generated and capital markets where value is created: this is only one of the stories they have to tell.

Having said this, it is important to note that there is a fundamental difference between the management of our criminal justice and our private enterprise systems:

Interactions between the police and district attorneys are coordinated. Interactions between customer and capital markets are largely ignored.

The purpose of this post is to document the interactions between customer and capital markets – the dual market performance – of international air express carriers.

THE BACK STORY
In my last post on Air Express Carriers: Creating Intangible Value I documented the relationship between shareholder value and competitive strategies of the top five international companies. I found that if FedEx (NYSE: FDX) had merged with TNT [AEX: TNT] in 2007 the combination would have dominated its peers in earnings productivity:

When management wrings the last drop of earnings out of each sales dollar they can do no better unless they change their business model -- or merge, which amounts to the same thing. The degree to which they achieve this goal is measured by relative earnings productivity. This is the ratio of actual earnings to maximum earnings.

The peer group in that analysis was the Swiss carrier Kuhne+Nagel [SWX: KNIN]; United Parcel Service (NYSE: UPS); and DHL [XET: DPW]. As insightful as this analysis may have been, it was missing an important dimension: the merged company’s dual market performance.

SEPARATE BUT EQUAL MARKETS
Remember, investors are (or should be) informed by two separate but equally important groups – the markets for customers and capital. Capturing a company’s performance in these dual markets is deceptively simple – compare its share of revenue with its share of value in a peer group.

In the first quarter of 2008 the German company was the hands-down market leader – in share of revenues [SOR]. The following chart shows that DPWN’s $24,890 million in revenue made it the international customer market leader with 41.4% of the group’s $60,062 million revenues. Followed by UPS with 21.1% of revenues. FDX was a distant third with a 16.4% share, just a little over two points above KNIN’s 14.0%. TNT picked up the balance with a SOR of 7.1 percent.

 

Comparing the same companies in the same quarter on share of value [SOV] tells an entirely different story. Now UPS takes a commanding lead with a 41.1% share of group market value.

These two charts offer just a peek inside the tent of dual market information. The full measure of this information can be found by creating a new metric I call the Risk Adjusted Differential [RAD].

DUAL MARKET PERFORMANCE
Measuring risk-adjusted differentials is so simple you probably will wonder why you never thought of it before. For each company:

• Calculate a series of value and revenue shares
• Take the difference between SOV and SOR
• Calculate the standard deviation among the differences
• Divide each difference by that standard deviation.

The result is a standard normal variable. Such a variable has two very useful properties: the mean is zero and standard deviation is one. The combination of these properties leads to the following control chart on the dual market performance of air express carriers.

The vertical axis in this chart is the risk-adjusted differential ranging from +16 to -16 points. The horizontal axis runs from the last quarter 2005 through the first quarter of 2006.

WILL INVESTORS READ THESE TEA LEAVES?
The green and red dashed lines at +2 and -2 represent the 95% confidence interval surrounding risk-adjusted differentials. Observed values of RAD greater than +2 or less than -2 differ significantly from the expectation (zero). Based on this information we can conclude that:

• UPS is 6 to 9 standard deviations above average
• TNT and FDX both are within expectations
• DPWN is 10 to 12 standard deviations below average.

Will the extraordinarily high and low dual market performances of UPS and DPWN be reflected in their future stock prices? Equally important, will the average performances of FDX and TNT be strengthened if a merger were consummated? Only the future will provide definitive answers. But my chapter on Competitive Stock Pricing will give investors some badly needed direction. Stay tuned for the next post in this unfolding saga of separate yet equally important markets.

Thanks for visiting. As always your comments are welcome.

~V

Mr. Smith Goes to Holland

COULD IT BE?
The previous post in this series was Air Carrier Wars: Managing Market Share for Optimal Earnings. In it I compared actual market shares with optimal ones for each of the five leading air express carriers: Kuhne+Nagel (SWX: KNIN); TNT (AEX: TNT); FedEx (NYSE: FDX); United Parcel Service (NYSE: UPS); and DHL (XET: DPW).

• DPW turned in the worst performance of the group. Its maximum earnings market share (31.8%) was a full 13 points less than its actual share (44.8%) of revenues.

• UPS turned in a much better relative performance with a maximum earnings share of 18.6% compared with actual share of 22.9%.

• FDX, TNT and KNIN all posted actual shares of revenue that were significantly less than their maximum earnings shares.

These findings begged two questions:

1. Would you dare tell Dr. Frank Appel, Chairman of DHL that he should harvest sales for earnings?
2. Could you convince Frederick W. Smith, CEO of FDX to increase sales by as much as 27% through organic growth or acquisition?

My answers were “No” and “Maybe,” in that order. The purpose of this post is to explore alternative answers to these two questions.

LATE BREAKING NEWS
Almost a week later a New York Times article published on May 29, 2008 reported that DHL planned to partner with UPS to restructure its loss-making US business.

The American unit would record an underlying operating loss of $1.3 billion this year, reducing to $300 million in 2011, Deutsche Post told a news conference at its headquarters on Wednesday.

DHL Express also planned to cut its network capacity by 30 percent and lower overhead and administration costs. Up to 10 percent of Express employees would be affected, Post said.

“We have promised to relentlessly focus on improving financial performance,” the chief executive Frank Appel said. “I am confident we have found a sustainable way forward for U.S. Express.”

I guess Dr. Appel didn’t need my analysis to know his company was throwing money down the drain.

SHOULD FDX ACQUIRE TNT?
Digging through TNT Facts I discovered that FDX and the Dutch express company have had a long standing partnership:

In the early 1990's GD Express Worldwide further expanded with key milestones being the introduction of a daily transatlantic freighter service, the development of an Asian Air Network and the delivery contract for all Federal Express shipments in Europe (bold added).

I also discovered talk of a FDX merger with TNT has been around for some time. The following comments surfaced in an article on the possibility:

As shares of the world's fourth-largest package carrier fizzled Thursday, Wall Street matchmakers couldn't resist thinking FedEx Corp. would be the perfect suitor.

Dutch transportation company TNT NV, a composite of three entities - the Dutch postal service, express delivery and logistics - lost more than 5 percent of its stockholder value Thursday, a day after a private German investor said he was putting together a group, including an unnamed strategic investor in the logistics field, to buy it.

"It would give FedEx a strong presence within Europe and the ability to offer comprehensive logistics and supply chain solutions," said Jon Langenfeld, analyst at Robert W. Baird & Co.

These discoveries turned on a light bulb in my mind: What would be the optimal vs. actual earnings of this combination?

FDX+TNT OPTIMAL EARNINGS
In a nutshell, more market share is a good thing only up to a point. After a company reaches that point, earnings begin to decline -- because the cost of the next share point suddenly exceeds its value. Where “that point” occurs depends on a host of things. And it may occur at a very low or a very high market share. But sooner or later that point will be reached. You can get a quick overview of this principle in my audio slide show: The Role of Maximum Earnings.

The following chart compares actual with optimal earnings of a merged FDX-TNT based on 2007 financial statements. It’s a surprising story.

 

The combined share of actual revenues would be 23.77% [FDX=16.25%; TNT= 7.52%]. The combined company’s optimal share of revenues would be 23.59% -- just 18 basis points lower than actual shares. Combined actual compared with optimal revenues would be $51.55 vs. $51.14 billion USD. Actual vs. optimal earnings [EBITD] of a merged FDX-TNT are virtually the same: $12.06 billion.

MR. SMITH GOES TO HOLLAND
If Fred Smith needs additional motivation to visit TNT in Holland to pursue a merger this earnings forecast should be it. The next question he might like to have answered is this: What would be the market value of the combined companies? The following posts in this series will explore this question using the principles of competitive stock valuation from my book Competing for Customers and Capital.

Thanks for visiting. As always your comments are welcome.

~V

Straight From the Gut

In Straight From the Gut Jack Welch said “If you’re not #1 or #2, fix it, sell it or close it.” His quote captured the spirit behind the development of the Profit Impact of Marketing Strategy [PIMS] studies by the Marketing Science Institute under the direction of Professor Robert D. Buzzell in the early 1970s. These two works have led nearly every CEO since then to believe that more market share means more profit.

A LITTLE HISTORY
I was the Associate Research Director of MSI in Cambridge, MA in the spring of 1969 when Bob Buzzell cut a deal with Sidney Schoeffler to expand his original study of General Electric divisions on a massive scale. You could say that I was there when PIMS was born. I left for Chicago's GSB that summer.

The PIMS data were used in hundreds of papers published over the next two decades. The first was an HBR article on The Impact of Strategic Planning on Profit Performance by Sidney Schoeffler, Robert D. Buzzell, and Donald F. Heany. A comprehensive review of the entire body of work is available in the PIMS Principles by Bob Buzzell and Bradley Gale published in 1987.

In 1983 I began to study the financial statements of public companies hoping to uncover the “real” relationship between market share and profits. This work culminated in Competing for Customers and Capital published in 2006. That book provides the theoretical underpinnings for these posts. One of the dominant principles is managing market share to optimize earnings. You can get a quick overview of this principle in my audio slide show The Role of Maximum Earnings.

In a nutshell, more market share is a good thing only up to a point. After a company reaches that point, profits begin to decline -- because the cost of the next share point suddenly exceeds it value. Where “that point” occurs depends on a host of things. And it may occur at a very low or a very high market share. But sooner or later that point will be reached.

AIR EXPRESS WARS
In my last post I discussed air express carrier share in relation to their markets for customers as well its equally important relation to the market for capital. The metric I used was the value-sales differential – the difference between each company’s share of value in stock markets and its share of revenue in service markets. For an overview of the theory and properties of this metric see my audio slide show Y'All Buckle That Seatbelt. I concluded the post with these four questions:

1. How is UPS able to outperform its peers?
2. Why the disappointing results from DHL?
3. What left FDX sitting on the bench?
4. How can TNT and KNIN move ahead?

One way to explore answers these questions is to consider the degree to which each company managed market share to optimize earnings.

MAXIMUM EARNINGS MARKET SHARE
The following chart shows actual and optimal market shares for each of the five leading air express carriers: Kuhne+Nagel (SWX: KNIN); TNT (AEX: TNT); FedEx (NYSE: FDX); United Postal Service (NYSE: UPS); and DHL (XET: DPW).

• DPW turned in the worst performance of the group. Its maximum earnings market share (31.8%) was a full 13 points less than its actual share (44.8%) of revenues. 
• UPS turned in a much better relative performance with a maximum earnings share of 18.6% compared with actual share of 22.9%.
• FDX, TNT and KNIN all posted actual shares of revenue that were significantly less than their maximum earnings shares.

OPTIMAL SALES
In ExecEd sessions most CEOs find it a fascinating theoretical exercise to discuss the pros and cons of maximum earnings market share. To them the concept even makes great cocktail party conversation. But when you translate those share numbers into sales revenues the sparks begin to fly!

Take the following chart of optimal sales revenues for the top five air express carriers as a case in point. Notice that the combined sales of these companies are close to optimal levels. Actual group sales were $216.8 billion while optimal sales were $228.3 billion. Optimal sales were only 5% greater than actual sales. This is an extraordinary accomplishment for such a complex global industry.

But would you dare tell Dr. Frank Appel that he should plan a sales cut from $97.2 billion to $72.7 billion -- by $24.5 billion USD -- in order to maximize earnings? Would any CEO willingly harvest that many sales for earnings? Sadly, that's what the senior managers of many legacy air passenger carriers are faced with in today’s market.

It might be easier to convince Frederick W. Smith chairman, president and chief executive officer of FDX that he should plan to increase sales from $35.2 to $48.2 billion – about $13 billion – either buy organic growth or through acquisitions.

What do you think Klaus Herms the CEO of KNIN would think about the prospect of increasing sales by 56% from $18.5 to $41.7 billion USD?

OPTIMAL COSTS
Of course all of the strategic recommendations that follow from maximum earnings market share have a dramatic impact on costs. The theoretical results are reported in the following chart.

As you might expect, given the close proximity of optimal to actual group revenues, their combined total operating costs at actual and optimal levels are almost exactly the same – separated by only 1.3% or $2.2 billion USD.

But, again, the picture is very different for DPW. Its optimal operating costs of $48.3 billion were over 62% less than its actual 2007 operating costs of $77.9 billion USD. Even UPS was over-spending in the amount of $7.5 billion or 22%.

FDX was under-spending by $12.1 billion (32%); TNT under-spent by $6.8 billion (33%); and KNIN under-spent by $20.5 billion, or nearly 61%.

OPTIMAL EARNINGS
All of the above brings us to the bottom line – earnings after total operating expenses [EBITD]. The following chart tells the story of actual vs. optimal earnings for each company and the group.

Combined optimal earnings ($53.9 billion) of the five companies were $9.2 billion USD, or 17%, greater than actual earnings of $44.7 billion. The majority of that was accounted for by DPW’s $5.0 billion short-fall.

The company with the most to gain is KNIN. If the company invested in demand to the point that its revenues were optimized it theoretically would increase earnings by 34% from $5.3 to $8.0 billion USD.

COULD IT BE?
If the Chairman of the biggest company in this group might not listen, why bother? Here’s how I look at it. I am writing to plant one seed here and another one there. Hopefully these seeds will grow and eventually a senior manager will listen and consider taking the recommended course of action. Either out of curiosity, when the potential gains are worth the risk. Or out of necessity, when they have no choice. And it really doesn’t matter what the motivation is so long as steps are taken in the right direction.

By the way, could it be that the value-sales differential of UPS was +20 points while that of DPW was -20 points partly because its actual earnings were five times closer to optimal than were DPW’s?

Thank you for visiting. As always your comments are welcome.

~V

The New Meaning of Market Share

Why is market share of revenues a strategic benchmark while market share of value is not even measured? There are several possibilities. Make a mental check of the following reasons that apply to your answer to this question:

_____ Market value is a financial metric
_____ Market share is a marketing metric
_____ Market value is too volatile
_____ Stock markets are efficient
_____ I haven't thought of it before
_____ All of the above.

Chances are you checked several if not all of the above. That’s why I decided to begin this new series. For the next few posts the goal will be to compare the performance of the top international air express carriers with the fundamental metrics introduced in my book Competing for Customers and Capital -- beginning with the new meaning of market share. Why look at air express wars? Because the results are both timely and unexpected.

AIR EXPRESS CARRIERS
In its 2007 annual report Deutsche Post World Net listed four companies in its peer group: “TNT, FedEx, UPS and Kuhne+Nagel.” You may have not seen these five companies on the same page before, because three of them are less known in the U.S.

Deutsche Post is listed on the Frankfurt exchange (XET: DPW) In the U.S. we know the company as DHL (which stands for the last names of its founders: Adrian Dalsey, Larry Hillblom and Robert Lynn). TNT is a Dutch company listed on the Amsterdam Stock Exchange (AEX: TNT), while Kuhne+Nagel is a German company listed on the Swiss Exchange (SWX: KNIN).

VALUE vs. REVENUE
The financial metric that links sales revenues to market capitalization is the value/revenue [v/r] multiple. It is a revealing metric. All the more so to me since I found the long-run expectation for the v/r ratio from 1950 through 2005 is nearly equal to 1:

The sum of market values over the 56 years was $244,850 billion USD. The sum of sales revenues over the period was $222,805 billion. The long run VR ratio was 1.10.

If you’re interested in the details see The Value/Revenue Ratio: A Semi-Long-Wave Marketing/Accounting Metric.

The following table reports sales revenues and market value for the top five international air express carriers and for the group as a whole in 2007. This is not a picture of a high-value industry. Without their indexed fuel surcharges the performance of these companies might look a lot more like air passenger cariers.

United Parcel Services (NYSE: UPS) is the only company in this table with a value/revenue ratio greater than one. For the group as a whole that ratio was just under 0.80. As revealing as these data are there is a more powerful metric for assessing the relationship between market value and sales revenue.

VALUE-SALES DIFFERENTIALS
The value-sales differential [VSD] is the difference between a company’s share of value [SOV] and share of revenue [SOR] in a peer group. Here's the critical distinction between the v/r ratio and the value-sales differential.  The v/r ratio is a meaningful metric with regard to the company as a stand-alone enterprise.  The VS differential is a meaningful metric with regard to the company as a member of a peer group. The two are not highly correlated.

The sum of value-sales differences across a sample of companies in the same time period is zero.  That's because it’s based on the difference between two numbers in sets that all sum to 100.  No matter how large or small the differential is for any given company, the sum of the differences for a cross-section of companies always will be zero.

In short, the value-sales differential is an interval scaled (whole numbered) index of a firm’s tangible and intangible market value relative to its peers. If you want a quick overview of the theory behind (and properties of) the VSD you’ll find one in my audio slide show Y’all Buckle That Seat Belt. If you’re interested in the details behind this metric you can download my MSI paper Marketing’s Impact on Firm Value or buy my book.

AIR EXPRESS DIFFERENTIALS
The following chart reports the share of revenue [SOR] in the left-hand bar and share of value [SOV] in the right-hand bar for the top five air express carrierss in 2007. The value-sales differentials appear between the bars with plus or minus signs. The green bars represent those companies where SOV is greater than their SOR. The red bars are for those companies where SOR is greater than SOV. The numbers in this chart were calculated from the data in the table above.

 

Investors awarded UPS with +20.5 point differential advantage over its peers: the company captured only 22.9% of the revenues and created 43.4% of the shareholder value in the group. The value created by UPS management was nearly double its sales churn.

Investors punished DPW with a -20.3 point disadvantage: the company generated 44.7% of the revenue but created only 24.4% of the value in this group. The sales churn generated by DPW management was almost double its value creation.

Meanwhile, FedEx (NYSE: FDX) was neither rewarded nor punished by investors: management generated 16.3% of the revenue and created 16.2% of the value. FDX sits on the sidelines. TNT was awarded a small premium while Kuhne+Nagel was discounted to a similar degree.

THE NEW MEANING OF MARKET SHARE
Market share is not just a marketing metric. It measures performance in both the sales generation and value creation domains. And the two interact in subtle but revealing ways. Here are some of the questions raised by the analysis of value-sales differentials in the air express carrier market:

1. How is UPS able to outperform its peers?
2. Why the disappointing results from DHL?
3. What left FDX sitting on the bench?
4. How can TNT and KNIN move ahead?

If you're not interested in the air express wars you might want to see how companies in which you own stock stack up against their peers. The calculations are simple. The implications may be more challenging.

Thanks for visiting. As always your comments are welcome.

~V

Charting a Demand Curve

In its 10-K filing (page 33) Amazon.com (NASDAQGS: AMZN) reported spending $1,174 million on outbound shipping in 2007. That amounted to 7.9% of revenues. The good news is Mr. Bezos also earned $740 million on those outbound shipments, a lot of it from the Amazon Prime Club annual membership dues.

A LITTLE BACKGROUND
In the ninth of this series in my ten posts on airline mergers, Passengers, Packages: The Paradox of Air Transport, I reported that FedEx (NYSE: FDX) and UPS (NYSE: UPS) had Michigan ACSI customer satisfaction scores around 80% in each of the last ten years. In the same period American Airlines (NYSE: AMR) and United Airlines (NasdaqGS: UAUA) barely broke the 60% customer satisfaction barrier. Claes Fornell and his colleagues have shown that higher ACSI consumer satisfaction scores are associated with high returns and low risk. Prompted by these results I asked:

Wouldn’t it improve consumer satisfaction if passenger airlines took baggage out of their equation? And specialized in transporting passengers? In economics this is called the “division of labor.”

In his Enquiry into the Nature and Causes of the Wealth of Nations Adam Smith wrote in the first paragraph of Book 1, Chapter 1:

The greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity, and judgment with which it is any where directed, or applied, seem to have been the effects of the division of labour.

You may think taking luggage handling out of the passenger carriers’ operational equation is great idea, or you may think it’s ridiculous. Either way you will agree it can’t happen unless express shipping can affordably be married to airline reservation systems. The purpose of this post is to chart a demand curve for express luggage services without any historical data. In doing so I hope to suggest the impact specialization might have on the price of express shipping services.

THE VOID IN PRICING DECISIONS
Price elasticity may be the most widely taught yet little used concept in marketing science.  As evidence, price elasticity is not even mentioned in the text of two classic pricing cases involving radical innovations: digital cameras and deregulated airlines.  The reason is not a failure of the underlying theory (see Chapter 10 of Lilien and Rangaswamy’s Marketing Engineering). Rather it’s due to the inability of management to connect price theory to the market realities of new product introductions.

The demand for brand new consumer products depends heavily on their price.  Digital camera demand is a contemporary example of this dependence. Here's what Gary DiCamillo, CEO of Polaroid had to say about digital imaging in 1997:

... the consumer market will be slower to evolve.  I don't think we'll see something major next year or the year after or maybe even by the year 2000…Will it become a big deal?  I don't know…I think there's revenue there, but I'm not sure about profit (Polaroid Corp., Rosenbloom and Pruyne 1997).

The uncertainty expressed in by Polaroid's CEO was based partly on the difficulty of articulating the relationship between price and consumer demand. Implicit in the CEO's statement "… I'm not sure we can make a profit… " is the tradeoff between increases in sales volume associated with decreases in price.

Perhaps more directly related to charting the demand curve for express luggage shipping is this comment by Rollin King, EVP of a startup called Southwest Airlines (NYSE: LUV):

Pick a price at which you can break even with a reasonable load factor… a load factor that you have a reasonable expectation of being able to get … without leading yourself down the primrose path and running out of money (Southwest Airlines, Lovelock 1975).

I’ll bet both Mr. DiCamillo and Mr. King had economics 101 in college. So why wasn’t price elasticity used in their assessment of demand for their innovations? Because there’s a huge knowledge void between drawing demand curves on a blackboard and estimating price elasticity in practice. Drawing demand curves is an art. Estimating price elasticity is a science. The folks at the airline carriers who are responsible for seat-specific pricing use a vast amount of historical data to price those seats in a way that optimizes revenues. Yet given less complete (and less applicable data) one can still make predictions about possible express luggage pricing.

LIMITED INFORMATION DEMAND CURVE
There are no data on what the large scale demand curve for express shipping of luggage might be if it were adopted by passenger carriers. But it’s possible to craft one without such data from the limited bits of information currently available. How? Begin by bracketing the limits of what demand might be. I identified the lower limit in my last post:

I ordered a new HP Laser Jet P2015 printer from Amazon.com The retail price was $449. I paid just $289.99. The next-day Amazon Prime delivery charge for this 28.9 pound package on UPS was $3.99. Based on this rate significant scale economies must exist in AMZN’s agreement with UPS as a result of huge shipping volumes.

One reader complained that I “conveniently neglected” to mention that Amazon Prime membership cost $79 a year. Actually, I didn’t neglect to mention this, I simply forgot how much it cost and didn't bother to look it up. In case you’re not a member here’s what Amazon Prime membership gets you:

Overnight Shipping for only $3.99 per item
-- order as late as 6:30 PM ET
Ship to any eligible address in the contiguous United States

I think you will agree that $3.99 for shipping a 30 pound package from Dallas to New Orleans next-day air is likely the lower limit that Amazon would pay for this service.

It’s just as easy to get the upper limit. Using the UPS shipping screen I priced a 30 lb box from New Orleans to Dallas standard overnight express at $142.50. I joined UPS online shipping to get this number, so it is the rack rate for a single shipment.

I also need a few points in between the upper and lower limits. The first two points I got from the logistics manager of a company that does $500,000 in UPS shipping services per year. He pays $89.64 to overnight a 30 lb package from New Orleans to Dallas. That’s a base rate of $73.20, plus a declared value charge of $1.80, plus a fuel surcharge of $14.64.

I also got an estimate of $42.75 for that same overnight package from another shipper that books a little over $1.5 million a year with UPS. Scaling that number back to $1 million per year gives a price of about $56. If these last two prices are representative it's likely when a shipper doubles annual volume from $500,000 to $1,000,000 they earn a 37% discount. So I ran this discount assumption up the scale doubling volume each time till it got close to that $3.99 AMZN cost. That happened at $64 million per year in annual shipping volume.

CHARTING A DEMAND CURVE
Because of its restrictive properties the constant elasticity demand curve works better than the linear demand curve in this context. It’s expressed as a power function in the following chart.

In this function annual shipping volume [q$] equals a constant [a] multiplied by the price to ship a 30 lb. package from New Orleans to Dallas [P] raised to the power beta, which is the constant elasticity of demand over the range of the function. Extrapolating this equation using the limited information described above creates the demand curve in this chart.

Based on the limited information and assumptions behind this chart, AMZN would reach a net per package rate of $3.53 at an annual shipping volume of $64 million. Note from the opening paragraph in this post that Amazon had a net outbound shipping volume of $434 million in 2007. It just may be that Mr. Bezos pays even less, on average, than $3.53 for that nationwide shipping rate! Only he knows for sure.

Remember there are no data on shipping luggage in the volumes that would occur if baggage were moved from the passenger transport into the package transport system. Such a move probably would create tonnages well beyond the current capacity of even the largest express shipper (DHL revenues are 50% greater than UPS).  If this chart is indicative of that future, demand is highly price elastic: beta is -1.5.

THIS AIN’T TEA LEAVES
In pricing a new product or service it’s necessary to imagine a future that cannot be projected from the past. Charting demand curves from limited information brings the power of theory to bear on the relationship between price and volume. As Peter Drucker famously said “The only way to predict the future is to create it.” But before you can create it you must imagine what it looks like. Isn't that what theory is designed to do?

Thanks for visiting. As always, your comments are welcome.

~V

Passenger Confidence and Airline Profitability

You may know of Peter Greenberg’s baggage handling philosophy. In a post on solving the lost baggage blues he famously said “There are two kinds of baggage: Carry on and lost.” His comment pokes fun at the airlines’ “mishandled baggage” problem. But there is another option. Must airlines carry passengers' baggage on the same plane?

HISTORICAL PERSPECTIVE
My last post in this series on airline mergers was ‘Power Offers’: Turning Airlines’ Mistakes into Value-Added Services. In it I reported that reuniting passengers with their mishandled baggage cost the airlines $3.8 billion in 2006. That represented about two-thirds of their 2007 profits. And the cost of mishandled baggage is bound to be greater in 2008. The way things are going with fuel prices it likely will exceed worldwide profits. This makes mishandled baggage a major problem. Not to mention the passenger frustration generated by mishandling their baggage.

The idea of ‘Power Offers’ is right out of the pages of a new book by J.C. Larrache: The Momentum Effect. My posts based on this concept have produced some serious thought by readers. For example, a Senior Business Analyst [S.B.A.] for one of the legacy carriers sent an email to me with a lot of really interesting comments on airline services in general and baggage handling in particular. For historical perspective the S.B.A. offered these thoughts:

If you look at the history of airline service, you can go back to a day when airlines HAD to provide as many incentives as possible to get people to use an airplane in the first place.  I think a lot of these services are rooted in the days when air travel was not as reliable, and there was a "risk" associated with it.  Airlines needed to provide a service level that may have been above what was really required.  Once the precedents are set, it's hard to peel back any services.

LUGGAGE FORWARD FLYING
In my last post I also suggested that Continental Airlines (NYSE: CAL) management should explore a partnership with Luggage Forward. Their services could be bundled into CAL’s online reservation system to create a value-added baggage handling option and thereby increase revenues as well as customer satisfaction. It suddenly became clear from the comments of my readers that an incremental step by a single carrier would be too little too late.

In this post I propose a bold bid for luggage free flying: Remove passengers' baggage from the air transport system worldwide. Suppose all the major carriers were to enter into a partnership with FedEx, UPS, DHL and the other shippers with Luggage Forward operating as the corner stone in a worldwide baggage handling solution. This would remove passenger baggage handling from airports and passenger carriers altogether. You should check out the baggage booking technology on the company’s website.

Why propose this bold step? The extraordinary challenges faced by the air carriers demand an extraordinary solution. For now let’s call this a worldwide Luggage-forward Express Shipping (LES) service. And keep in mind the double meaning: LES means more -- less hassle combined with more profitable air travel.

I know it sounds unrealistic to move baggage handling our of the passenger air transport system into the express shipping system. But then again it must have sounded unrealistic to remove mail delivery from the US postal system. Here’s what the S.B.A. from a legacy carrier had to say about this idea when I suggested it to him in an email:

If we started with a clean sheet today, I could see how airlines would save a bunch of money by not accepting personal luggage.  Not only would this save money, but the cargo area of the plane could be used for legitimate revenue generation.  Air cargo is a good business for the airlines, so the win would be twofold - reduced costs, increased revenue.  Plus, by not carrying luggage, the airlines could eliminate a real pain point for travelers.  I admit, there seems to be little downside to it.

Not only would these advantages accrue, but the considerable governmental infrastructure and personnel dedicated to inspecting passenger baggage could be shifted to another pressing need in air travel: Inspecting existing cargo plus all that revenue earning cargo that would replace passenger baggage.

A whole host of questions pop up. The first ones are operational issues. The others are potential deal breakers.

OPERATIONAL QUESITONS
Here are nine operational questions that must be answered as part of the planning process. All of these questions (in italics) were raised in private email correspondence with the S.B.A. cited above. The answers are my own first take on each question.

1)   What about bad weather days? The LES option avoids this problem because baggage never enters the air transportation system. If the passenger doesn’t travel, the bags are returned. If his or her travel is simply postponed, the baggage will be there when the passenger arrives.

2)   Can passengers get their baggage back without paying for the shipment? Yes, this kind of risk can be covered by a “failure to fly” insurance fee built into the price. The fee would be based on the actuarial tables of cancelled flights. It would be far less than the shipping costs themselves.

3)   How does the DOT or the airline track "lost baggage"?  They are no longer responsible for lost baggage. It’s insured by LES for full value in partnership with a top rated insurance company. The cost would be a function of declared value.

4)   How are changes to the contract of carriage handled? The agreement would release the carrier from any contractual liability for baggage handled by LES.

5)   What about itineraries involving multiple airlines? The LES option avoids this problem because baggage never enters the passenger air transportation system.

6)  What if a carrier is not willing to accept this as a standard practice? A consortium agreement in which all major carriers participate would be necessary.

7)  Can’t passengers book their own baggage shipment with one of the express services? Yes, but they could not free-ride – consortium rates would be available only through an airline reservation system.

8)  How would migration from the current model to an LES model be handled? Momentum would need to built quickly in the airlines’ partnership with LES for it to be successful. The technologies are available to support a rapid migration.

9)  Would airlines be stuck with the sunk costs of all the processes built around baggage handling? No, their infrastructure would be sold to governments at fair market value to increase their capacity to inspect cargo.

DEAL BREAKERS?
Here are three questions that speak to the feasibility of the LES proposal:

Express Shippers’ Capacity. Could express shippers scale up to handle worldwide passenger baggage delivery? At first blush it seems likely they could since the top three shippers had combined revenues in 2007 just over $158 billion USD and employed 1.2 million people. That’s nearly $44 billion more revenues than the nine carriers included in my analysis of airline mergers and over three times the number of employees. What’s needed is an estimate of the number of “passenger baggage equivalent” deliveries of these express shippers.

International Consortium. What organization would have the stature within the industry to develop and administer performance standards? IATA is a likely candidate since its mission statement includes helping “airlines help themselves by simplifying processes and increasing passenger convenience while reducing costs and improving efficiency.”

Affordability. Would LES scale economies, coupled with increases in carrier cargo revenue and the elimination of mishandled baggage, drive down the cost of an express baggage service enough to make it affordable when bundled into airline reservations? This is the toughest nut to crack.

With your help I’ll try to provide more substantive answers to these questions in my next post. In the meantime, thanks for visiting.

As always, your comments are welcome.

~V

Full disclosure: I do not hold a position in Luggage Forward or any commercial carrier or shipper. I am not being paid for these posts, nor do I have any prospect for future payments from any of the companies that might be involved.

Value-Added Services

Nicola Clark reported in her article in the December 12, 2007 issue of the International Herald Tribune that the IATA predicts 2007 worldwide airline profits will be around $5.8 billion. Reuniting passengers with their mishandled baggage cost those same airlines $3.8 billion in 2006. And that number is bound to be greater in 2008. It probably will even exceed worldwide profits. This makes mishandled baggage a major problem for airlines.

UPDATE
This post is part of a series on airline mergers that led me to search for ways to improve passenger satisfaction and airline profitability. Carriers are caught between a rock and a hard place. The downward pressure on ticket prices means that earnings don’t increase with market share. As a result scale economies don’t work, so mergers likely won’t solve the problem. For details see my post on Why Airline Mergers Don’t Work.

Late this afternoon Susan Carey and Paulo Prada reported in their Wall Street Journal article that “Delta, Northwest Could Unveil Merger as Early as Tuesday.” I guess the CEOs of these airlines would rather merge than manage. The story goes on the say they “… could go ahead without the support of Delta's 6,000 pilots … leaving negotiations with Northwest's 5,000 pilots for a later day.”

I hope those CEOs read this post and begin rethinking their business model. They might become more creative in managing passengers’ baggage and thereby turn the costly mistakes of mishandled baggage into value-added services. Or simply put, create ‘Power Offers’ through superior baggage handling. That’s a bundle of services which would lead to ‘vibrant satisfaction’ among airline passengers. See Creating Power Offers.

BACKGROUND
Creating vibrant satisfaction among airline passengers is no small feat. Based on J.C. Larreche’s book The Momentum Effect, plus my own 50 years of air travel experience, I proposed that Continental (NYSE: CAL) management create a “Certified Airtravel Valise” [CAV] program. Since CAL offers travel to over forty international destinations, these would be included in the execution of a CAV service.

I explored the first step in delivering this service in my post on Delivering Power Offers. It became clear that Continental management must establish a partnership with the U.S. Transportation Safety Administration’s [TSA] Registered Traveler service if the idea of a CAV were to ever get off the ground. It also became clear that baggage cannot be boarded without TSA inspection. That brought up the need for additional partnerships.

Here I explore partnerships with the FlyClear personalized check-in service and the Luggage Forward shipping service as the second step in executing power offers in air travel. The goal is to create a more engaging travel experience as well as value-added revenue.

CONTINENTAL BEHIND THE CURVE
Today a search for the word “baggage” returned 1,224 hits on Continental’s website. A search for “TSA” returned 36 hits. The phrase “Registered Traveler” returned an empty window that said “! Please Enter a Valid Search.” Doing the same search for Virgin Atlantic returned the following link to a January 30, 2007 press release. Here are some excerpts from that press release:

... Clear® Registered Traveler announced today that Virgin Atlantic Airways will be the first airline to bring Clear to travelers at Newark Liberty International Airport.

"Superior customer service and stress-free travel are two things that our travelers have come to expect from Virgin Atlantic," said Chris Rossi, Vice President Sales and Marketing, North America. "Clear Registered Traveler will serve to enhance the Virgin Atlantic experience."

British Airways (LSE: BAY.L) also has partnered with the FlyClear service.

FLYCLEAR
What do travelers get for enrolling in FlyClear? Here are some of the benefits listed on their website:

• Get through security faster, in under four minutes.
• Don’t worry about unpredictably long lines.
• Access a designated security lane with special benefits.
• Allow our attendants and concierges to help you as you go through the Clear lane.
• Use your Clear card at airports nationwide.

And here's a link to a list of the seventeen U.S. airports and hours in which the Clear Lane service is available now. How does one become a registered traveler?

Clear’s simple, two step enrollment process begins online.  Applicants create an account and fill-in basic biographic information.  Then, applicants must go to a Clear enrollment location, where our attendants will verify two forms of government-issued identification, and capture a photograph, your fingerprint images and your iris images. This information is used to allow you access to the designated Clear lane at the checkpoint.

As of March 31, 2008 Clear had signed up over 127,000 people nationwide for a fee of $100 (plus a TSA application fee of $28). I’ve applied for a Clear Pass myself. It's easy.

The FlyClear service could be a compliment to a “Certified Airtravel Valise.” Attendants and concierges might sheppard first-class baggage through the line without the passenger if a proposal by CAL and Clear were approved by the TSA.

LUGGAGE FORWARD
Another option mentioned in my post was the use of express shipping by FedEx (NYSE: FDX) or UPS (NYSE: UPS). It turns out the market is way ahead of me on this one. A specialized point-to-point shipping service for air travel baggage already exists. It’s called Luggage Forward. Here’s what the company says about this service:

Shipping luggage ahead to your destination creates a true luxury travel experience. Luggage Forward can send luggage to your hotel, cruise ship, golf course or vacation home within the United States, Europe, Asia, South America, Australia or virtually any other destination. Forwarding luggage allows you to save time at the airport by avoiding the long check-in lines and skipping the wait at the baggage carousel.

In short, your baggage never enters the air travel system so it hardly ever gets misplaced or lost. Here’s how Aaron Kirley, a founder of Luggage Forward, has described The Growing Lost Luggage Problem:

When you relinquish your luggage to the airline agent at the check-in counter, the luggage begins a complicated journey to the belly of your plan. The conveyor system is owned and operated by the airport. Airlines pay terminal fees to cover the cost of baggage handling and the TSA regulates the baggage handling process. Although the airlines are responsible for your luggage, they have little control over the TSA’s baggage handling process and therein lies one major point of failure. 

What’s the list price of Luggage Forward services? If you’re traveling with a large family the price can add up pretty quickly, even if you use the economy rates. The March 26, 2008 MSNBC report on why “Weary travelers bypass hassles of checking bags” found that:

When Adam Kolodny took his wife and four children on a ski trip to Colorado, it cost him $1,200 to ship eight large bags of ski equipment and baggage round trip through Luggage Forward. But compared to the mess it would've caused at the airport, the price was worth it, said Kolodny, a 45-year-old resident of Great Neck, N.Y.

Today, a refundable coach-fare from JFK to Denver through Minneapolis on Northwest (NYSE: NWA) for two adults and four children runs about $8,000. That $1,200 luggage shipping charge amounts to a 15% premium. Traveling with four children and eight large bags of ski equipment plus luggage that would seem a bargain to some passengers.

Though Luggage Forward may not offer the deep emotional engagement that a Certified Airtravel Valise program could create among first-class passengers, it suggests a way for Continental to deliver a power offer to coach-class of passengers as well. The combination might reduce the costs of mishandled baggage while enhancing revenue.

VALUE-ADDED SERVICES
Should CAL management explore partnerships with FlyClear and Luggage Forward? Either or both of these services might be bundled into CAL’s online reservation systems to create a variety of value-added baggage handling options and thereby increase customer satisfaction, reduce the costs of mishandling baggage and increase revenues. We used to call this a "win-win" proposition. A 'power offer' by another name is just as powerful. What do you think?

Thank you for visiting. As always, your comments are welcome.

~V

Delivering a Power Offer

Continental Airlines (NYSE: CAL) should explore partnering with the U.S. Transportation Safety Administration [TSA] as part of a larger effort to increase passenger satisfaction. But they better act fast because Virgin Atlantic and British Airways (LSE: BAY) are way out front on this one.

In my last post Creating Power Offers I suggested that Continental should take more responsibility for handling the baggage of first-class passengers. The objective of a ‘Power Offer’ is to create ‘vibrant satisfaction’ among Continental's first-class passengers.

Creating vibrant satisfaction among airline passengers is no small feat. None the less, guided by Professor J.C. Larreche’s new book The Momentum Effect (plus my own air travel experiences) I proposed that Continental management create a “Certified Airtravel Valise” [CAV] program:

Whenever the carrier’s first-class travel partner flies to any domestic destination, his or her CAV flies on the same plane (without inspection) and is delivered to the hotel or other venue where the passenger is staying. This saves schlepping it from baggage-handling to the taxi and on to the hotel.

On the return trip the CAV is picked up at the hotel by the carrier and loaded on the flight to his or her local airport.

Since CAL offers travel to over forty international destinations these also should be included in the delivery of a CAV service.

MIXED RESPONSES
It’s fair to say the responses to my proposal were mixed. One comment from a world-traveling physician said:

Something that's worked for me well was, if at all possible, to keep a set of clothes, toiletries, etc , (permanently) at the frequented destinations. At one point, I was 'commuting' to Tokyo from NY almost every other week. … once I got a taste of this 'distributed clothes cache' idea, it became so seductive that I have ended up with caches in San Francisco, … Chennai (India), Geneva and London. … it may also make sense to create these caches 'locally': my Chennai & Geneva caches were, for instance, built mostly from purchases in India/Switzerland.

The comment from an airline pilot took a different direction:

The airlines have absolutely zero say in creating passenger enhancements to clearing security. The TSA has been entirely intractable in permitting any changes to ease the pain & no matter how much the airlines care, the TSA will do what it wants to do… The TSA certainly is not going to automatically permit bags with no positive control to board aircraft.

DESIGN vs. EXECUTION
At the end of my last post I concluded that it’s easier to define than to execute a power offer. Here’s what JC says about the difference in his book:

The principal difference between design and execution relates to where the two activities are conducted. Although design must, of course, be externally focused to be successful, the process is largely internal, where the firm has control over the variables. On the other hand, execution happens in the outside world, where unexpected reactions and events can make a mockery of the best laid plans and force rapid reengineering of offers that once appeared perfect. The first step in execution is to ensure that the design is properly implemented as originally intended, but that’s only the first step (p. 134).

As I see it, there are two critically important external issues to be addressed if Continental management were to consider executing a Certified Airtravel Valise program. These are:

(1) Understand the policies of the U. S. Transportation Safety Administration with regard third party participation in the boarding process.  If it can’t be done, as the airline pilot suggested above, forget about it.

(2) Explore the possibility of partnering with other companies that already provide supporting services. Since our world-traveling physician found the idea so seductive, there must be companies that already provide solutions to parts of the process.

In this post I address the first issue: partnering with the TSA. Next week I’ll follow-up with the second issue by exploring other supporting partnerships.

REGISTERED TRAVELER PROGRAM
On January 10, 2008 the TSA published an extensive report on its efforts to partner with the private sector in providing enhanced air traveler services, including check-in and baggage handling. The report Registered Traveler Program Standards is available online. The introductory paragraphs that appear on the website summarize its objectives:

The Transportation Security Administration and private industry developed the Registered Traveler (RT) program to provide expedited security screening for passengers who volunteer to undergo a TSA-conducted security threat assessment (STA) in order to confirm that they do not pose or are not suspected of posing a threat to transportation or national security.

The RT program is market-driven and offered by the private sector with TSA largely playing a facilitating role. TSA is responsible for setting program standards, conducting the STA, physical screening at TSA checkpoints, and certain forms of oversight. The private sector is responsible for enrollment, verification, and related services.

Notice that physical screening at TSA checkpoints is necessary even for registered travelers:  baggage cannot be boarded without TSA inspection.

Among the services the TSA is supporting in partnership with their sponsors and service providers are:

(1) dedicated or integrated check in lines and lanes;

(2) enhanced customer service for RT participants, such as divesting assistance, concierge service for luggage, and parking privileges; and

(3) discounts for service or concessions.

The RT program has been in development for several years. Yet few carriers have committed to it. The report cited only four airline participants at the time of its publication in early 2008:

Air France (operating out of Terminal 1 at JFK);
AirTran Airways (operating out of central at LGA);
British Airways (operating out of Terminal 7 at JFK);
Virgin Atlantic (operating out of Terminal B at EWR); 
Virgin Atlantic (operating out of Terminal 4 at JFK).

A TSA PARTNERSHIP?
Partnerships cost little and ancillary revenue from services that formerly were free is not the road to vibrant passenger satisfaction. Should CAL management explore partnering with the TSA to create its own Registered Traveler program? What do you think?

Thank you for visiting. As always, your comments are welcome.

~V

Creating a Power Offer

My post on Why Airline Mergers Don’t Work concluded with this double whammy:

Painful price elasticity combines with zero earnings elasticity to squash earnings in the proposed merger between Delta (NYSE: DAL) and Northwest (NYSE: NWA).

The statement was based on the principles in Competing for Customers and Capital, perhaps the only analysis of its kind that could identify this crippling dilemma.

What’s an airline CEO to do in this situation? I recommended they read J.C. Larreche’s book The Momentum Effect for possible cures to what ails them. Here’s what Sir Richard Branson, who knows a thing or two about the airline business, says on the cover jacket:

This book shows you how to build momentum and leave your competitors trailing in your wake.

What might an airline CEO learn from it? I admit, perhaps not the same things I have learned. But here is one insight that jumped from the pages of The Momentum Effect [TME] as I read.

VIBRANT SATISFACTION
The relationship most air carriers have with passengers never develops beyond their onboard experiences, online booking and ticket purchases. As Professor Larrache said:

There is no emotional connection. To generate the momentum effect requires a much deeper and more committed relationship than that offered by passive customers who just don’t complain. Companies should measure their success by the number of delighted customers they have—people so thrilled with a product or service that they can’t help but tell others about it.

Aiming to satisfy customers is not enough. That is an average, complacent, and mediocre goal. Momentum-powered firms are more ambitious in their customer satisfaction objectives. Their target is truly intense, can’t-imagine-any-better satisfaction—vibrant satisfaction (p. 152).

Would offering a non-stop flight in place of a connecting one create vibrant satisfaction? Not really. While non-stop flights are desirable, we’ve all learned to live without them. Finding a non-stop flight is great, but it does not create vibrant satisfaction. A non-stop flight is not something for which you would say: I can’t imagine anything more satisfying in air travel. What sort of air travel service might lead you to express vibrant satisfaction?

WHEN LESS IS MORE
We often hear the idea that “less is more.” But that concept always is expressed in terms of money. The following sentence from TME explains when less is more from the passenger’s point of view:

For [passengers], less should mean that they get exactly what they need and nothing more, with no superfluous elements that create complexity and could destroy value (p.27).

Reading this sentence started me thinking: In my experience are there any airline services that create complexity and destroy value?

SIX TRIPS TO WPB
Two of my sons and grandsons live in West Palm Beach, Florida. So I travel there on a first-class senior fare about six times a year. Currently that fare runs about $1,100 per round-trip. All the flights offered by Continental Airlines (NYSR: CAL) have a plane change in Houston. Usually I check one large suitcase carefully packed with shoes, shirts, sport-coats and several suits surrounding a MacBook Pro wrapped in a towel, plus toiletries packed in plastic bags or snap-tight containers.

I’ve been making this trip on the same CAL connecting flights six times a year for several years. Even so the TSA inspectors take my checked bag apart and throw my suits, shirts, ties, socks and shoes back in wrinkled mess with a little flyer announcing their inspection. As if I couldn’t see they had been there.

THE CURSE OF CHECKED BAGGAGE
On every trip we pay so much attention to our luggage that one might think it mattered more than ourselves. We pack our clothes and toiletries in a suitcase, carry it to the airport, check it and expect the TSA to inspect it. Then we roll it to a taxi or shuttle, take it to a hotel or other venue, unpack and lay out stuff for the next day. And the days after.

Then we replay the process in reverse by returning the clothing and toiletries to our suitcase. We carry it to the airport, check-in for TSA inspection, retrieve it from baggage handling at the end of the flight and take it home to unpack. If it's not lost in handling!

Finally, our local cleaning service picks up the dirty clothes to wash and/or dry clean them. Two days later the service returns the cleaning and we put it put away. There it waits in our dresser for the next trip.

This is an endless, superfluous cycle of baggage handling, and re-handling, and re-re-handling. A cycle of unnecessary complexity that often destroys what ever value might be created by an on-time arrival. Why do first-class airline passengers need to check their baggage? If you think about it, we really don’t. We don’t need “baggage handling” as we know it. What we actually need is another set of clothes and toiletries at our destination.

How could an airline provide another set of clothes and toiletries at a passenger’s destination? By taking on more of the responsibility for them. There are at least two possibilities.

EXPRESS SHIPMENT
Probably the simplest option is for the carrier to partner with FedEx (NYSE: FDX) or UPS (NYSE: UPS) to pick up our baggage from home the day of our departure and deliver it to our destination timed with our flight arrival. With this option our baggage never goes thorough the passenger air transportation system. No baggage to carry to the airport and check-in. No TSA inspection. No waiting at the baggage carrousel to pick it up. Then, just before our return flight, the express service picks up our baggage at the hotel and returns it to our home timed with our arrival.

But this simple solution has one major drawback. It’s simple for the air carrier, but not for the passenger. For example, the express shipment option avoids some of the curses of checked baggage, but not all of them. It's less likely to get lost. But, we still have to pack the suitcase, make an appointment to have it picked up by the express shipper and wait for the truck to arrive. Then on the return trip we have to be home to receive the baggage.

We still must sort the clothing and give it to our cleaning service. Then store it away till the next time we need it. When that day arrives, we must repack the suitcase and wait for the express shipping service to pick it up. We never think of these chores as much of a burden because we always do them. But what if we didn’t need to?

PERSONAL VALET
Another -- far more personal -- option is for the carrier to create a travel partnership with each of its first-class passengers. Roughly speaking, here’s how a personal valet service built on that partnetship might work.

Each partner is issued his or her own Certified Airtravel Valise [CAV]. A coded travel-partner number is etched in the rigid frame of each CAV. Multiple CAVs are available in various sizes and functions (e.g. hanging bag, shoe case).

Initially, travel-partners pack their own set of clothing and toiletries in their valise. Then, before the very first flight with the service, the CAV is picked up by the carrier and stored in a special section of its baggage handling facilities at the local airport. This secure section is dedicated to handling only the airline travel-partners’ baggage. The security must be such that the TSA will approve CAVs as pre-inspected baggage. Securing TSA approval would require careful planning of security safe-guards by the airline.

Whenever the carrier’s first-class travel partner flies to any domestic destination, his or her CAV flies on board the same plane (without inspection) and it is delivered to the hotel or other venue where the passenger is staying. This saves schlepping it from baggage-handling to the taxi and on to the hotel.

On the return trip the CAV is picked up at the hotel by the carrier and loaded on the flight to his or her local airport. Then it's delivered to the passenger’s own valet service where it is dry and/or wet cleaned, repacked in the travel-partners CAV, picked up by the carrier and stored in the private airport lock-up till the next trip. The costs of the cleaning services are billed to the travel partner’s personal account with that vendor. The value of this service will be built into first-class fares for travel partners. This is what JC would call a “power offer.”

EFFECT OF POWER OFFERS
Power offers have a huge effect. First, they create compelling value both for the customer and for the company. Second, a deep emotional engagement drives vibrant satisfaction. Third, a power offer cannot be easily duplicated by a competitor. This leads to higher customer retention levels.

Power offers are a continuous and essential activity in creating and sustaining momentum. As JC describes it:

The accelerating effects of four related components: power offer, vibrant levels of customer satisfaction, retention, and engagement, lend a potent thrust to momentum. These four components support each other in a virtuous circle (p. 151).

EXECUTING A POWER OFFER
It’s easier to define a power offer than to deliver one. What’s required for Continental Airlines to deliver on the promise of a passenger valet service for its first-class passengers? What do you think?

Thanks for visiting. As always, your comments are welcome.

~V

Full disclosure: I recommend this book as a co-author with a long history of collaboration.

Reconfigure or Reregulate

Over the 30 years since airline “de-regulation” Delta (NYSE: DAL) management spent $2.35 on M&A for every $1 worth of value they created. Northwest (NYSE: NWA) spent $1.61 for every $1 worth of value created. Southwest (NYSE: LUV) spent just $0.03 on M&A for every $1 worth of value it created. For the details behind these numbers see my last post "Delta/Northwest: Evaluating Company Performance in a Dysfunctional Industry."

VALUE MIGRATION
The Preface to Adrian Slywotzky’s 1996 book Value Migration begins with this declaration:

Value Migration describes an outside-in approach to strategy. It begins with the customer and works its way back. It requires thinking from the environment back into the company’s capabilities and direction.

No surprise Mr. Slywotsky devotes an entire chapter to domestic airlines. In “Migration to a No-Profit Industry” he points to a “hidden competitive advantage” that has become the standard of the day:

Ironically, these highly leveraged carriers had a hidden source of competitive advantage – bankruptcy court. While some carriers … failed completely, the courts often allowed bankrupt carriers to continue operating while they restructured. In 1983, Continental Airlines sought protection and temporarily shut down. A few days later, when it reopened, Lorenzo had voided union contracts, fired more than half the workforce, and dropped more than half his routes, lowering costs significantly (p. 125).

Also, no surprise Mr. Slywotsky had no idea “What if anything, will break the pattern toward zero profits” in the airline industry. I have a few ideas on how to do just that. But, first I offer a new perspective on Competing for Customers and Capital in this dysfunctional industry that gives some support to those ideas.

TWO MARKETS, TWO METRICS
Airline companies, like those in every other industry, compete in two separate but equally important markets. As result of the profound differences in how they operate, the markets for capital and customers are described with entirely different theories. Their performance is based on entirely different metrics. And the gap between the two is big enough to drive an 18-wheeler through.

If there is one take-away from this story it’s this:

To understand how the markets
for customers & capital interact
you must measure that interaction.

A company’s stock market performance is measured by its market cap. Its performance in consumer markets is measured by its sales revenues. Table 1 compares the performance of DAL with NWA and LUV over the period from the close of the 2nd quarter 1994 through the close of the 4th quarter 2007. The starting quarter in this series is the first one in which data were available for all eight domestic airlines included in this analysis.

Table 1

The first row in this table reports the market value of the three companies and the group for the first and last quarter in the series, followed by the percentage changes in each. The second row reports the sales revenues in the same way.

What can one conclude from the market value data in Table 1? For one thing, all three carriers, as well as the group, appear to have performed quite well. In particular, NWA appears to be a standout with a 237% appreciation in its market cap. Almost double LUV’s value creation over the period. Of course, the picture isn’t as rosy when you think back to the opening comment in this article: NWA spent $1.61 on M&A for every $1 of value it created.

What can one conclude from the sales revenue data in this table? Again, all three airlines appear to have done well. Especially noteworthy here is LUV’s 277% increase in sales revenue. But then again, if these revenues were adjusted for inflation, the result would be far less rosy.

The corrections needed to present an “adjusted” picture of performance are easy to make. But we didn’t know till now is how to capture the performance in these two markets with a single metric.

TWO MARKETS, ONE METRIC
Everyone is accustomed to measuring a company’s market share of sales revenue. Before now, few have ever considered measuring a company’s share of market value. Measuring both share of value and share of revenue simultaneously leads to the creation of a single metric that captures the interaction between the market for capital and customers.

Consider Table 2 where market shares of value and revenue are presented for the 2nd quarter of 1994 and the 4th quarter of 2007.

Table 2

In June 1994 DAL created 17.1% of the group’s $16.0 billion market value [from Table 1]. In the same quarter DAL generated 17.8% of the group’s $16.6 billion in sales revenues [from Table 1]. The difference between DAL’s share of value and its share of revenues was -0.7 points. By the close of the 4th quarter 2007 this difference had grown to -1.9 points. NWA’s value-revenue differences went from -5.6 to +1.6 points over the period. While LUV’s differences went from +19.5 to +24.3 points.

There were 53 quarters of data between the beginning and end of the series reported in the Tables above. Almost 14 years. How do you capture the effects of the value-revenue differences between these two points?

One way is to calculate the standard deviation of the value-revenue differences over the entire series. This is a measure of volatility commonly used in finance to create discounted rates of return. The standard deviation in DAL’s value-revenue differences over the 55 quarters was 6.9 points. The standard deviation in NWA’s value-revenue differences was 5.2. LUV’s standard deviation was 21.2. Call these a measure of the risk associated with each company’s relative performance in both capital and customer markets.

Dividing the value-revenue differences in each period by their risk yields the “risk-adjusted” differences. DAL’s risk-adjusted differences went from -0.1 to -0.3; NWA’s went from -1.1 to +0.3; LUV’s went from +0.9 to +1.1 over the 55 quarters. What do these numbers mean?

The risk-adjusted differential [RAD] is a measure of the interactions between capital and customer markets. In technical terms, within a strategic group, RAD is a standard normal variable with mean zero and standard deviation one. If you are interested in the theory and analytical details behind this metric you can find out in the audio slide show Y’all Buckle That Seat Belt. It runs about 18 minutes.

Think of RAD as a control variable. Companies with risk-adjusted differentials greater than zero are value creators. Those with RADs less than zero experience value migration. Since the standard deviation is one, a company that posts RADs greater that +2.0 is creating significantly more value than its peers. A company that posts RADs less than -2.0 is experiencing significant value migration.

DELTA’S ERATIC GLIDE
Chart 1 reports the value creation & migration pattern for Delta Air Lines over the same 55 quarters.

Chart 1

Through the first 29 quarters ending in June 2001 Delta's pattern of value creation and migration was erratic, reaching a high point of +1.6 in September 1999.  Delta clearly was tipped into decline by the attacks on the World Trade Center and the Pentagon. And the company continued to shed value right through December 2007.

NORTHWEST’S LONG SLIDE
Chart 2 is a plot of Northwest’s value creation and migration in each quarter. The series opens with three negative RADs beginning with the 2nd quarter of 1994. Then the company moves through a run of nine quarters of value creation peaking at +1.7 in December 1995.

Chart 2

In June 1997 NWA entered into a period of continuous value migration that lasted through the 4th quarter of 2006. Initially, this value migration had nothing to do with the attacks on the World Trade Center and the Pentagon. But it certainly was aggrevated by those attacks as Investors continued to shift progressively more value away from NWA, finally culminating in bankruptcy.

SOUTHWEST’S HIGH RIDE
As Chart 3 shows, the value that migrated from its competitors went largely to Southwest. The company posted positive risk-adjusted differentials in every one of the 55 quarters in this study.

Chart 3

Beginning in March 2000 Southwest posted value creation numbers greater than 1.0 in every quarter but March 2007. This performance is extraordinary. Chart 4 shows why.

Chart 4

This is a plot of the distribution of risk-adjusted differentials for a large sample of companies in the study of Marketing’s Impact on Firm Value published by the Marketing Science Institute in 2003. Only 12 of the 337 companies in this study posted risk-adjusted differentials greater than +2.0 in all ten years between 1991 and 2000. Southwest Airlines did that for 18 quarters during, arguably the most turbulent period in domestic airline history.

RECONFIGURE OR REREGULATE
Given this history, and the failure of many large scale mergers, there are two ways to fix the airlines.

One is to break them up and reconfigure the parts. For example, spin off Northwest’s Asian routes along with Delta’s European routes and combine them in a public company that would offer formidable competition to Air France KLM, British Airways, and Lufthansa. Since all the aircraft in this new international airline would be big, this reconfiguration might go a long way toward solving the union's seniority problem. Then the domestic routes of both companies not required for international operations could be merged in a point-to-point/multiple-hub network. Then the aircraft, routes, landing rights, and gates that don’t fit the reconfigured domestic network could be auctioned off to the highest bidders. No doubt Southwest would buy more than a few of these and hire many of their employees too.

What's the other way to fix the airlines? Reregulate the supply side of the industry. What do you think of these options?

Thanks for visiting. As always I welcome your comments.

~V