EVIDENCE TO THE BOARD OF DIRECTORS WHY CHINA RESOURCES ENTERPRISE SHOULD ENTER THE CHINESE AIRLINE INDUSTRY
The Passenger Airline Sector
Background
Gross margin shows how profitable a firm is (Investor words 2006). It is the difference between the total sales revenue minus cost of goods sold, or when expressed as percentage, further divided by the former (Investopedia 2006). It is also used to measure the efficiency of a manufacturer and mark-up of a retailer (Money Chimp 2006). In aggregate, it quantifies both the income-generating capabilities of a firm as well as its cost-saving strategies and productivity programs. With this respect, this presentation will deal on gross margin management of a particular firm listed in Hong Kong Stock Exchange called Cathay Pacific Airways Limited (COPAL).
Generally, the financial aims of managing gross margin are to determine how to minimize the cost of goods sold through scrutiny of the cost of producing and buying inputs, inventory looses and declined value of unsold inventories during a certain period (Superior Investor 2006). In the marketing side, it aims to establish a value-creating marketing mix that involves products, price, place, and promotion aspects to stimulate sales capability. In this view, COPAL will be analyzed based on these key areas with benchmark for comparison being China Southern Airlines Company Limited (CASCO), which is a top/ major competitor (Hoovers 2006).
COPAL and CASCO are both competing in the aviation industry in Hong Kong although the former is considered the leading player in the region while the later is named as the largest in China (Hoovers 2006). The size of CASCO, however, is undermined by Copal’s capability to earn. In 2004 records, COPAL has a total of .0 billion in sales, which is trailed by .0 billion dollar sales of CASCO. Also, net sales favored the former at 0 million versus a loss million of the latter. If any, CASCO had excelled in year-on-year sales growth. COPAL operated at a mere 90 global destinations compared to Casco’s 540 routes including 435 domestic destinations (Hoovers 2006). On the contrary, the COPAL is a member of an alliance wherein British Airways and AMR’s American Airlines obtain membership. Currently, the CASCO shrank its operations into 320 routes where 260 domestic, 39 international and 20 Hong Kong operations (CASCO Website 2007).
Financial Side of Gross Margins
Table 1: Related Cost of Good Sold Items
2005 (in HK$ billions)
2004 (in HK$ billions)
COPAL
CASCO
COPAL
CASCO
Flight Operations
28.2
18.6
23.4
10.0
Maintenance
4.5
4.4
3.7
3.3
Depreciation, Leasing, Servicing
5.5
9.7 (with amortization)
5.1
5.6 (with amortization)
As shown, the bigger number of employees (30,000 against 15,000), aircrafts (200 against 90) and destinations (300 against 90) being held by CASCO does not reflect to its cost of good sold as COPAL overtake most of major expenses. Other factors may affect this scenario.
Table 2: Selected Factors that Affect Table 1
2005
2004
COPAL
CASCO
COPAL
CASCO
Revenue Passenger Kilometers
HK B
HK B
HK$ 57 B
HK$ 36 B
Passenger Load Factor
78.7%
70%
77.3%
69%
Revenue Tone Kilometers
HK.8 B
HK.9 B
HK.4 B
HK.4 B
Tone Load Factor
67%
63.3%
68.7%
62.6
Cargo and Mail Carried
1.1 M tones
775,000 tones
900,000 tones
545,000 tones
Available Seat Kilometers
82 B
88.3 B
74 B
53.7 B
Cost per Available Tone Kilometer
HK.19
HK.43
HK.07
HK.41
Aircraft Utilization
12.6 hours/ day
9.6 hours/ day
12 hours/ day
9.9 hours/ day
With the additional data, COPAL was able to overtake the expenditures of the bigger CASCO because it utilizes its passenger and cargo spaces more as reflected by load factors. The passenger load factor is higher for COPAL despite CASCO having more available seat kilometers. As a result, flight operation expenses rose partly due to additional flight attendants that are needed including more amenities inside Copal’s aircrafts. Also, relatively narrow spaces require increased ventilation and air-conditioning in which CASCO has lesser burden to face with. And even though COPAL has higher cost per available tone kilometers, it is paid-off by higher cargo and mail being carried and revenue tone kilometers compared to CASCO. The former also has higher aircraft utilization that means that its efficiency measures require additional expenditures in fuel, overtime work, etc.
By cross-referencing the first two tables, it suggested that even though COPAL uses its aircraft more frequently and derives more revenues by doing so than CASCO, their maintenance and depreciation expenses are rather non-distant. Questions such as accident rate, expertise and diligence of employees, aircraft policies to passengers, among others are suspicious to CASCO. High losses from wear and tear or lower aircraft space utilization from both passenger and cargo are non-reflective of COPAL. Higher flight operations of COPAL which is at least 50% higher than CASCO is also rationalized by additional expense incurred in higher passenger and cargo load factor. Lastly, COPAL has also good returns from its leasing contracts that makes lease payments headache free.
Table 3: The Revenue Side
2005
2004
COPAL
CASCO
COPAL
CASCO
Revenues (HK $)
50.9 B
36.7 B
42.7 B
23 B
Gross Margin (HK $)
10.6 B
(1.2 B)
8.9 B
0.872 M
Gross Margin* (%)
20.8%
(3%)
20.8%
3.7%
* Note: Gross Margin / Revenues
This table shows how well COPAL converted its relatively high cost of good sold to positive cash flows. On the other hand, CASCO while deceptively looking efficient in Table 1 has shown its lack of income generating capability. Its lower expense may illustrate the gap of its internal organization and associates unlike COPAL, which gained from its investment effectively.
Marketing Side of Gross Margins
Table 4: Comparative 4Ps
CAP
CASCO
Products
Passenger Transportation, Catering, Aircraft Maintenance, Ground Handling, Cargo Carrier (COPAL Website)
Passenger Transportation, Catering, Aircraft Maintenance (CASCO Website)
Price
More Expensive (Opinions)
Less Expensive (Opinions)
Place/ Distribution Channel
Global Network
Mostly Local in PRY
Promotion
Spent HK9 M in commissions
Spent HK.5 B in promotions and sales
CAP has been able to maximize the productivity of its aircrafts because of its global network. In fact, it is one of the founding members of One World Global that afford it to use over 600 destinations worldwide. Also, it is a major stake holder in ASK Air Hong Kong Limited, an all cargo carrier, which serves the entire Asia. These aspects, along with the presence of key associates, are what CASCO misses that resulted to minimal costs and minimal revenues at the same time despite of its size and prominence in the PRY.
Further, since Hong Kong is a commercial hub for international business transactions, COPAL benefits the income status of foreign passengers who are most likely prefer better service than better price. In this view, its expensive fees and tickets are less intimidating for the specific market. In the contrary, CASCO transports mostly in Chinese provinces and major cities that placed it within the cheap-waged workforce, thus, unable to increase revenues through better services since customers tend to be price sensitive. In effect, it can only concentrate its resources and capabilities highly in being cost-effective with little product development or diversification. In this reason also, CAP is less pressured to promote its products and attach some lucrative incentives to stimulate demand.
Trends and 2006 Assumptions
COPAL derived its highest operation expense and year-on-year increase in its fuel account at HK billion and 48.5% respectively with an aggregate flight operation expense at HK.2 billion (COPAL Website 2007). This makes its flight operations very expensive at times of oil price hikes and cited by the company to be a significant barometer of its future earnings (Lancaster 2006). Since COPAL treats fuel factor as an external variable, maximizing the space of its aircrafts for both passenger and cargo can only attain efficiency. As presented in the preceding discussions, it can be assumed that fuel prices has relatively less impact for minimizing the cost of goods sold by COPAL (refer to Table 2).
The capacity and breadth of its services is reflective on its hub presence, fleet growth rate, technology and partnerships. It cannot stimulate its revenues without growing and upgrading its value chain. At best, it cannot achieve integrated cost leadership and differentiation strategy, which is cited as the most value-adding business strategy (Hitt et al 2003 p. 135). To resolve these issues, COPAL intensifies its service flights in Los Angeles, London and Xiamen including additional services in Amsterdam, Beijing, Nagoya, Rome, Frankfurt, etc. It also has pending deliveries for Boeing and Airbus aircrafts while it is the pioneering user of Internet in global aviation industry. In this view, including its code sharing feats and increasing membership in One World, it can be assumed that it can stimulate revenues and be efficient at the same time (i.e. all else equal).
Implications
1. Being lean but mean, COPAL has been able to become Hong Kong’s premier airlines. The key to this success is the type of market that it caters wherein its marketing mix can be easily and profitably controlled. Also, with strategic alliances, it can minimize the risk and its associated cost of underutilizing its resources particularly aircrafts that can aggravate its resource depreciation and maintenance costs. As a result, it is recommended that it should continue its global diversification to pinpoint the high-end portion of the market. In this endeavor, however, it should caution its hub development and other operating forecasts against the socio-economic indicators of the country.
2. Its diversification and increased service to selected destinations around the globe does not only increase its overhead cost but also maintenance particularly fuel costs. Currency exchange risks should be hedged in order to minimize the impact of oil price escalation. It can also use forward contracts in buying fuel wherein frequent demand will be the contract motivation since it has relatively greater aircraft use.
3. It is also recommended for COPAL not to compete with the low-end market (e.g. competing in the provinces of PRY). Lowering its prices especially in abrupt manner can imply decreased in service value. Since this can happen when efficiency persists, it can divert the derived gains for expansion, replacing old aircraft models or increasing its stake in its good performing portfolio like its cargo services. This recommendation is validated by the fact that COPAL was recognized as the “Airline of the Year 2005” from a UK-based research company (COPAL Website 2007). This means that the international market responded how well it deliver its services, thus, they feel the higher COPAL tickets and fees worthy for the derived satisfaction.
Credit:ivythesis.typepad.com
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