Potential Market Impacts of Liberalization Options on the Commercial Canadian Aviation Industry

Research conducted for the Canada Transportation Act Review

Report prepared by
Fred Lazar

April 2001

Potential Market Impacts of Liberalisation Options on the Commercial Canadian Aviation Industry

Fred Lazar

Schulich School of Business

York University

April 2001

1.0 EXECUTIVE SUMMARY

1.1 Introduction

Deregulation of the Canadian airline industry has not produced the outcomes forecast and desired by proponents of deregulation; therefore, a second phase of deregulation appears to be necessary. This second phase involves opening up the Canadian market to all players.

As one of the very few, original sceptics about the potential "competitive" impacts of deregulation, I do not support re-regulation of the industry. However, all markets require a set of rules/regulations in order to function efficiently; otherwise, there is anarchy in the market place and the outcomes are far from desirable either for economists or policy makers. Thus, what needs to be considered is the appropriate set of rules to govern the airline industry.

I favour the use of bilateral negotiations and agreements to continue to open up the Canadian market. I am strongly opposed to unilateral actions for three reasons:

· They are unlikely to produce the outcomes expected by advocates of this course of action and if I am right, then policy makers will be left with few, if any, options to deal with the repercussions.

· There is no reason to give up important bargaining chips because there is more at stake than possible consumer benefits.

· Unilateral actions greatly diminish the probability of Air Canada surviving as an independent carrier, and there are important economic and social benefits from having a Canadian carrier.

1.2 Key Issues

The primary objective of this report is to assess the effects of alternative means for permitting foreign entry into the domestic market on the competitive landscape in both passenger and freight aviation services in Canada.

There are three sets of options considered in this report:

· Increasing the foreign ownership limits to 49% of the voting equity in Canadian licensed airlines;

· Granting foreign-based airlines modified sixth freedom rights, consecutive cabotage rights and/or stand-alone cabotage rights;

· Allowing foreign-based airlines or foreign investors to start up and own up to 100% of the voting equity of an airline that is licensed to operate only in the Canadian market (rights of establishment, franchisees).

The entry options do address several of the barriers that either may prevent further entry by Canadian companies or may reduce the rate of entry. The possibility of entry into the domestic Canadian market by incumbent US airlines for example, should increase the pool of management talent. As well, these airlines should be able to access capital at competitive rates, have access to distribution channels and be able to match or improve upon the competitive advantages of incumbent Canadian airlines. On the other hand, entry by US airlines will face the same infrastructure barriers as any Canadian entrant, and there may be few markets in Canada that offer any potential for profitable entry. Relaxing the current foreign ownership limits without changing the effective control requirements will address, at best, the capital barrier. This will do little to overcome the management barrier, infrastructure, market size and incumbent advantage barriers.

But is there any need to open up the domestic Canadian market to foreign entry?

Among the possible answers to this question are the following:

· Entry will be incremental since no further entry by a Canadian company is expected or some Canadian entrants will fail even without new foreign entry. (Two have already been acquired - Royal Airlines and Canjet.)

· Entry will be incremental and accelerate the pace of entry - the current rate of entry is "too slow".

· Entry will provide more effective competition even as it displaces some or all of the new Canadian entry to date.

But how many city-pair routes in Canada can support competition? That is, how many can support more than one carrier? If the Canadian market is one characterized by a predominance of very thin routes, then entry possibilities are limited at best, and they already may have been exhausted.

1.3 Entry to Date in Canada

Since the takeover of Canadian Airlines (CAI) by Air Canada, both de novo entry and entry by incumbents through capacity expansion have taken place. It is important to note that expansion by existing carriers, including Air Canada, is a form of entry. All entrants have had previous airline experience, including Canjet and Skyservice/Roots. The only new entrants, in the sense of de novo entry, are Canjet and Roots Air.

The entry experience to date demonstrates the importance of the following factors in attracting additional capital into the airline industry in Canada:

· Importance of management experience in the airline industry;

· Importance of perceived opportunities following the demise of CAI;

· Success of Westjet.

But the industry is now undergoing another round of consolidation.

· Royal and Canjet are being acquired by Canada 3000.

· Roots Air lacks a viable business model and may fail.

The failure of entrants will have negative impacts for the remaining incumbents (excluding Air Canada) and for future groups in attracting additional capital. Thus, entry by Canadian companies may be past its peak.

It is also important to consider that no entry into the regional airline markets has occurred. Many Canadian city-pairs cannot support more than one airline. Many such routes are regional airline routes.

1.4 Alliances

There are four major global alliances, and it is unlikely that there will be more than four given the latest round of consolidation in the US and the need for a global alliance to have a US airline as a member.

In Australia, two of the alliances are currently represented (Oneworld and Star) because two domestic carriers (Qantas, Ansett) have survived. No attempt has been made by the other alliances to enter the Australian domestic market.

In Canada there used to be two, now there is one alliance represented. Is there any interest by any of the other three groups to enter the Canadian market? Does the Canadian market matter in the global route network? Regardless, there is limited scope for new entry by foreign carriers given the existence of four global alliances.

1.5 Lessons from Australia

There are several interesting lessons for Canada from the experience in Australia during the past year.

· There appears to be room for two national airlines in Australia.

· Only one domestic airline has taken advantage of the recent structural changes and market opportunities to enter into the market, and Impulse Airlines was almost forced into this strategy in order to survive.

· The new Foreign Ownership Guidelines did lead to the entry of Virgin Blue. But the willingness of the Queensland Government to offer concessions and financial assistance might have been even more important for attracting Richard Branson to Australia.

· Both entrants operate primarily in the very dense east coast triangle: Melbourne-Sydney-Brisbane - similar in many respects to the eastern triangle in Canada.

· The entry of a foreign-owned carrier has effectively blocked entry by any other domestic airline.

· Incumbents do respond aggressively to entry, especially when it occurs on the largest city-pair routes.

· Entry does lead to lower fares and yields.

· Virgin Blue is expected to withdraw or sell out within the next 12 to 18 months.

1.6 Lessons from the US

There are also important lessons from the US.

There has been a steady, if not spectacular growth in the aggregate market shares of low-cost, low fare airlines in the US from 8.8% in 1986 to just over 15% in 1999. Much of the gain reflects the continued success and growth of Southwest Airlines. Many entrants have failed and continue to do so. The failure of the start-ups post 1997 is largely attributable to poor management, weak business plans and inadequate financing. But entry continues, with de novo entry by JetBlue and expansion by Southwest, AirTran, Frontier and Midway.

However, just as entry is a characteristic of the US market, so too is consolidation. ValuJet was merged into AirTran in 1997. American acquired Reno Air and AMR Eagle bought out Business Express in 1998. Delta acquired Atlantic Southeast and Comair in 1999. United is in the process of taking over US Airways, and American has an offer to buy TWA and selected US Airway assets (accounting for approximately 20% of USAir's traffic).

Consolidation is spurred by the desire to continually increase the scope and scale of the route networks. With the exception of Southwest Airlines, the major US carriers have concentrated on building up the feed through and the size and number of their hubs. Fortress hubs reduce the competitive impacts of entry and provide a basis for resorting to capacity, flight frequency, scheduling, frequent flyer programs, travel agent commission overrides and alliances for attacking new competitors.

As part of the strategy to strengthen their hub operations, the major airlines have developed close relationships with regional airline partners. Indeed, the regional airline industry in the US has been dramatically transformed. The introduction and increasing role of regional jets have expanded the role of regional airline partners/subsidiaries and their importance in the hub-and-spoke networks of the major airlines. Regional jets have become very important in the on-going development of hubs by the major airlines and one of the niche airlines.

Substantial growth opportunities for Southwest, AirTran, and Midway exist in the US market, so they likely have limited interest in Canada.

1.7 Conclusions

Foreign entry could occur in the following manner:

· Adding an extra Canadian leg to spokes currently terminating in a Canadian city (consecutive cabotage);

· Creating a domestic Canadian carrier (the Ansett or Virgin Blue strategy). A domestic Canadian carrier could be structured as a shuttle service in short, high density markets (the Impulse, US Airways Shuttle models); a hub-and-spoke network with a hub in Toronto or perhaps in Calgary, Winnipeg or Montreal; or as a point-to-point service (Westjet, Southwest models).

· Serving Canadian cities through existing US hubs (modified sixth freedom) such as Minneapolis (Northwest, Wings Alliance), Milwaukee (Midwest Express), Chicago (American, Oneworld Alliance), Detroit (Northwest), Cleveland (Continental, Wings Alliance) or Cincinnati (Delta, Skyteam Alliance).

With the exception of creating a domestic Canadian carrier, US airlines are more likely to consider entry into the Canadian market if they are to be granted modified sixth freedom rights or some form of cabotage rights. Non-US airlines do not operate US-based hubs that could be used with modified sixth freedom rights. As for utilizing consecutive cabotage rights to serve the domestic Canadian market, non-US airlines cannot offer the frequencies required to attract the business traveler and there is a greater likelihood of delays with overseas flights, further diminishing the attractiveness for the business traveler. But the Qantas experience in Australia under the country's Two Airline Policy indicates that non-US carriers could offer very cheap fares for the leisure traveler in Canada who is much less concerned with frequencies and punctuality.

Low cost, low fare entrants into the US market and more recently into the European Union market have generally attacked the hub-and-spoke networks of the incumbents to open up "new markets". The geography and population distribution of the Canadian market greatly limit the potential for hub-and-spoke networks. So too does the importance of Toronto Pearson Airport and the limited potential to create a hub at this airport.

A point-to-point network does not provide start-up airlines the same latitude to create "new markets" by over flying hubs. Rather, any entrant must go head-to-head in competition with the incumbents unless there are good secondary airports in major urban centres. This suggests that there may be more limited scope for the creation of a domestic Canadian airline by foreign airlines or investors.

What is the likelihood that new entry may in fact occur if the Canadian market is opened to foreign airlines and investors? Who might enter and in what markets?

· US carriers are unlikely to take advantage of the consecutive cabotage right because their focus is on building up their hubs and in the process they are minimizing the number of one-stop spokes to their respective hubs in order to reduce the spreading out effect of delays at any one of their hubs throughout their entire networks. US carriers are more likely to consider the feasibility of adding a new non-stop spoke or additional frequencies on existing non-stop spokes to Canadian cities than to add another leg to an existing spoke to a Canadian city.

· The modified sixth freedom right is more likely to appeal to US carriers. US airlines that already operate to more than one Canadian city from their hubs can quite easily offer a through fare connecting some Canadian cities. This possibility exists for US airlines with hubs near the Canadian border, otherwise, the inconvenience of longer flights might offset the benefits of lower fares for the time sensitive traveler, and on transcontinental flights. Leisure travelers on the other hand, might be attracted by low fares and more time consuming connections through a US hub.

· US airlines and possibly foreign carriers such as Virgin Atlantic, British Airways and/or Singapore Airlines might consider starting up a Canadian subsidiary. The track record of the Virgin Group to date does not provide much confidence that it will enter the Canadian market, or if it does, that it will be a long-term force in this market. Singapore is a member of the Star Alliance, so it is unlikely to enter into the Canadian market without the prior approval of Air Canada. British Airways is facing too many other problems to be concerned with feed from the Canadian market.

· In light of the latest round of consolidation in the US, the existence of four distinct global alliances involving the major US airlines and the close links between the largest, independent regional airlines and the major airlines, the number of airlines that might potentially take advantage of greater access to the Canadian market is likely to be quite small. Neither Southwest nor any of the niche airlines in the US is likely to enter the domestic Canadian market because entry into the domestic Canadian market does not fit with their current route development strategies.

· Of the four alliances, only the Star Alliance group has a presence in Canada. Of the other three, only the Oneworld alliance had a presence in the Canadian market prior to Air Canada's takeover of Canadian Airlines. Therefore, it would appear that the Oneworld group might have the strongest incentive to re-enter the Canadian market. But this group could re-enter through a marketing or code share agreement with Canada 3000. If the foreign ownership limits are increased to 49%, British Airways, American or the Oneworld group as a whole could take a significant equity stake in Canada 3000. Either of these options would involve a rather modest investment and thus would minimize the risks of gaining access to the Canadian market.

Nevertheless, if new entry by foreign airlines or foreign investors does occur, how might this affect the plans for further entry by Canadian companies and what might be the net effect on competition in Canada?

· The scope for entry by foreign airlines is limited as is the likelihood that entry will occur. So the potential impacts might appear to be rather limited as well. But some entry will take place and given the size of the Canadian market and the fragility of the industry, particularly at this time of slower economic growth, even a limited degree of entry could have significant impacts on the Canadian airline industry.

· Modified sixth freedom rights or cabotage could decimate the Canadian cargo industry unless the scope clauses at the major cargo airlines in the US are changed to allow subcontracting to Canadian companies.

· We should not expect a free-for-all of entry if new policies are adopted by the federal government to encourage new entry into the Canadian market. The Canadian market, with the exception of a very small number of city-pairs, is very small. Hence, whatever entry does take place will likely come at the expense of further expansion by the Canadian incumbents and likely will risk the future viability of one or more of these companies, unless the only change is a relaxation in the foreign ownership limits.

· The airline industry is very cyclical. Because the industry has high fixed costs in relation to revenues, a small change in load factors or fare levels has a large impact on profits. Therefore, the longer or the sharper the slowdown in the economy, the poorer are the prospects for survival for new entrants regardless of whether or not foreign airlines choose to enter the Canadian market.

· A relaxation of the foreign ownership limits might do more to ensure the survival of domestic competition than any other policy changes. This could increase the sources of capital available to Canadian airlines, and for the well-managed carriers, access to more sources of capital should also reduce the costs of capital. But any change in foreign ownership limits without a change in "effective control" provisions might prove to be of limited value.

· As for the argument that a quasi monopoly may be inefficient and operate with too high a cost structure, the problem is not one of an absence of competition, but rather a lack of internal incentives and controls to limit waste.

In the absence of any policy changes, I would expect the following:

· Canada 3000 will continue to grow but will be marginally profitable;

· Westjet's financial performance may have peaked;

· Roots will be history;

· Air Canada's financial performance is at risk because of high debt loads, a slow growth economy, substantial integration costs and the effects on increased domestic competition to date.

If policy changes lead to some foreign entry, then I would expect the following:

· There will be limited entry at best - there are a very small number of markets in Canada that provide entry opportunities - and the entry may end up displacing Canadian companies (in terms of the routes they operate and/or the number of frequencies they provide on existing routes).

· Even limited entry will weaken the financial performance of Canada 3000, Westjet and possibly Air Canada (depends on whether the changes are the result of unilateral actions or bilateral agreements and the potential of Pearson as a northern tier hub).

2.0 INTRODUCTION

2.1 Objectives

This report has the following primary objective: To assess the effects of alternative means for permitting foreign entry into the domestic market on the competitive landscape in both passenger and freight aviation services in Canada.

In order to achieve this objective, the following issues will be addressed:

· The scope for new entry into the Canadian market;

· The likelihood that new entry might in fact occur if the Canadian market is opened to foreign airlines and investors;

· The potential market impact of new entry, if it does occur -

· How would it affect the plans for further entry by Canadian companies?

· What would be the net effect on competition? How many airlines would likely survive?

There can be either de novo entry - new companies enter into the market - or entry by incumbents through capacity expansion. In the airline industry, entry by incumbents can occur by increasing the daily frequencies on existing routes or by introducing service on new city-pair routes. Since the takeover of Canadian Airlines by Air Canada, both types of entry have occurred and the entry by incumbents has taken both forms. Canjet and Skyservice's Roots Air have provided de novo entry. Incumbents such as Westjet and Royal Air have expanded their scheduled service operations by adding more frequencies on existing routes and starting new routes (see S. 2.3 below).

In light of these positive developments to date, one must ask why there is any need to open up the domestic Canadian market to foreign entry. There are two possible answers to this question.

One, no further entry by a Canadian company (either de novo or by existing competitors to Air Canada) is expected. If this is the reason for considering opening up the Canadian market to foreign airlines, then it is necessary to ask why no further entry is expected. Perhaps, the acquisitions of Royal Air and Canjet by Canada 3000 are a precursor of a new round of consolidation in the airline industry in Canada.¹ Whether or not this may be the case, are there barriers to further entry by Canadian airlines? If so, what are they and are there other options to overcome these barriers? Among the possible barriers are management, access to capital, infrastructure constraints, limited market/profit opportunities, and competitive responses by Air Canada. How will increased competition/entry by foreign airlines/investors overcome any of these barriers?

Second, the rate of entry is "too slow". This response presumes some efficient market equilibrium with an "optimal" system of route networks, services and fares and that the current rate of entry by Canadian companies will produce this equilibrium outcome in "too long" a period of time. Setting aside the important questions of how one defines "too slow" or "optimal" in the context of the domestic airline industry, it is again necessary to ask why the rate of entry is too slow. Are there barriers slowing the pace of entry? If so, what are they and are there other options to deal with them? And how will entry by foreign airlines/investors overcome any of these barriers?

While this report will not directly address the question of whether there is a need to open up the domestic market to foreign entry, this report will examine whether foreign entry is likely to occur, and if so, how it might impact the Canadian market.

Policy makers must be in the position to have a realistic view of the possible consequences of a new policy regime. As will be discussed in S. 2.4 below, the proponents of the initial phases of deregulation of the airline industry misjudged the ramifications, and thus, policy makers in Canada and the US are now dealing with the consequences - increased consolidation of the industry.

2.2 Entry Options

There are three sets of options by which the Canadian market can be opened further to foreign airlines and investors. The current foreign ownership limits can be relaxed, but not eliminated altogether. The Canada Transportation Act requires that holders of air carrier licenses be "Canadian", controlled in fact by Canadians, and that at least 75% of their voting interests be owned and controlled by Canadians. Economic equity held by non-Canadians can exceed 25% to a maximum of 33%. The US rules restrict foreign ownership to a maximum of 25% of the voting interests and a maximum of 49% of the economic interest. In special circumstances, the Department of Transportation may permit non-US citizens to hold up to 49% of the voting equity.

The Canadian rules could be changed to allow non-Canadians to hold up to 49% of the voting equity in Canadian licensed airlines. This would be comparable to the existing rules in Australia. The Canadian-control requirement could be maintained by limiting the equity holdings by any one foreign entity or related group to 25% or less.

A second option involves, either unilaterally or through bilateral agreements, granting foreign airlines modified sixth freedom rights, consecutive cabotage rights,² and/or stand-alone cabotage rights.³

Modified sixth freedom would allow a US carrier for example, to carry Canadian passengers between two cities in Canada through a US hub.⁴ Consecutive cabotage would enable a US carrier to operate a domestic route in Canada as an extension of one of its transborder routes. For example, Northwest Airlines could extend its current Detroit-Toronto route to Ottawa and pick up Canadian passengers in Toronto who are traveling to Ottawa. Stand alone cabotage would allow any foreign carrier to operate purely domestic routes in Canada without any connection to their domestic networks. So a US carrier for example, could provide service between Winnipeg and Vancouver even though it did not operate any transborder route with either Winnipeg or Vancouver as the Canadian end-point.

The third option is a variant of granting stand-alone cabotage rights. Foreign airlines or investors could start up and own up to 100% of an airline in Canada that operates only Canadian domestic routes. Australia changed its Foreign Investment Review Board Sectoral Guidelines in 1999 to permit foreign interests to own up to 100% of an Australian domestic airline. Thus far, two domestic carriers in Australia are foreign-owned - Ansett and Virgin Blue (see S. 4.2 below).

2.3 The Canadian Airline Industry: Review of Market Developments

Following the takeover of Canadian Airlines by Air Canada in December 1999, several airlines announced plans to enter/expand into the scheduled service market domestically. Westjet, the major surviving scheduled service airline in Canada, expanded its service in Western Canada and entered into the Eastern Canada market by selecting Hamilton Airport as its base of operations in this region. Royal Air transferred some aircraft from its cargo and charter operations to expand its scheduled service operations in Eastern Canada and across the country. Canada 3000 raised new equity to finance the acquisition of additional aircraft and its expansion into scheduled service operations domestically and internationally. Skyservice, a charter carrier, partnered with Roots, a clothing retail company, and raised equity capital to acquire aircraft to start a scheduled airline catering to business travelers. Roots Air commenced operations at the end of March serving Toronto-Vancouver and Toronto-Calgary. Finally, the IMP Group started up a new airline - Canjet - to provide low fare service in Eastern Canada with Winnipeg as the current western terminus for the route network. Of all the incumbents, only Air Transat did not enter into the scheduled service market.

At the end of January, Canada 3000 acquired Royal Air thus reducing the number of competitors in the domestic marketplace. According to the Chair for Canada 3000: "The combined airline represents an excellent fit and brings together Canada 3000's long haul, international service with Royal's short haul domestic capabilities."⁵ Canada 3000 is now in the process of acquiring Canjet as well.

Canada 3000

Canada 3000 has been building up its scheduled service over the past few years as a means to grow and achieve better utilization of its fleet. The company has set out the following strategic objectives in order to grow revenues and profits and improve profit margins:

· Operate a broad, flexible and global route strategy responsive to demand;

· Maintain a diversified route mix that is not dependent on any one market or route;

· Vary scheduling to avoid direct competition;

· Maximize aircraft utilization;⁶

· Target the price sensitive leisure and business travelers;

· Create demand by offering low fares;

· Maximize passenger load factors;⁷ and

· Establish its track record and reputation across Canada and internationally.

Canada 3000 has selected routes in many different markets in Canada and internationally, including the transborder market, and has not restricted itself to a defined route strategy. By combining both charter and scheduled services, the company targets any market in the world where it believes that there is potential for profitable entry. The company currently serves over 90 destinations worldwide, with roughly an equal mix of Canada domestic; transborder; trans-Atlantic; and traditional winter routes to the Caribbean, Mexico, and the South Pacific.

Canada 3000 is Canada's second largest airline and in 1999, the company carried 2.7 million passengers. Canada 3000 operates in over 20 city pairs in Canada.⁸ For example, the company offers at least one non-stop flight per day (Monday to Friday) out of Toronto to each of the following: Halifax, Moncton, Montreal (two flights), Winnipeg, Calgary and Vancouver (2 flights). The company plans to increase the number of frequencies on the transcontinental routes out of Toronto and some transborder routes, and start new non-stop service to smaller cities in Canada and the US when it begins to receive the new A319s on order.⁹ They are scheduled to start entering the company's fleet by November of this year.

The company's current fleet (excluding the aircraft to be acquired from Royal and Canjet) consists of the following:

Source: Canada 3000 "Annual Information Form", filed with SEDAR.

Canada 3000 will expand its current fleet as it is committed to leasing four A319s.

The company's revenues have increased steadily and quite sharply during the past three years, and with the exception of fiscal year 1999 (ending April 30), the company's net profits also have increased. The growth in revenues and profitability has continued into the first half of fiscal 2001. The company's cash flow from operations has been quite strong and it has been able to generate cash in fiscal years 1999 and 2000 and during the first six months of fiscal 2001.

Sources: Canada 3000 "Annual Information Form", "Prospectus", and "Second Quarter 2001, Financial Statements" filed with SEDAR.

Canjet

Canjet began operations with used B737-200s in September, serving Toronto, Ottawa, Halifax and Windsor. It terminated the Toronto-Windsor route in October and has since expanded service to include Montreal, St. John's, Moncton and Winnipeg. The company currently operates six B737-200s and provides the following daily non-stop service (Monday-Friday).

Source: Canjet website.

Royal Air

Royal Air consisted of three divisions. The passenger air transportation division provides both charter and scheduled services. The other two divisions are Royal Air Cargo, specializing in freight services for couriers, freight forwarders and the auto industry, and Conifair, which performs maintenance services for Royal's fleet and external customers.

The company's domestic scheduled service was structured as a hub-and-spoke network with Toronto serving as the hub. The following cities are currently provided with scheduled daily service: Halifax, Montreal, Ottawa, Toronto, Winnipeg, Calgary, Edmonton and Vancouver. The company launched its scheduled domestic services, targeted at business travelers, in 1999. The services were started by transferring two convertible B737-200s from the Royal Air Cargo division. The merger between Canadian and Air Canada provided a window of opportunity for the company to enter into this market and scheduled services offered a means to optimize the use of its passenger aircraft fleet during off-peak periods (by season and day of week).

In September 2000, the company doubled its domestic flight schedule and increased flight frequencies and started new city-pair routes. As well, during 2000, Royal acquired an additional B737 for use in domestic scheduled service market. Prior to its takeover by Canada 3000, the company operated the following daily schedule (Monday-Friday) of non-stop flights:

Source: Royal Air website.

The Royal Air fleet used by the passenger air transportation division consisted of:

Source: Royal Air website and "Annual Information Form", filed with SEDAR.

In addition, the cargo division operated three B737-200s and two B727s.

The company's operating revenues increased by almost 50% in fiscal year 1999, but declined about 5% in fiscal 2000, in part because the company discontinued the operations of its subsidiary Royal LeClub in fiscal 2000 and divested of Royal Vacations in fiscal 1999. In both fiscal years 1999 and 2000, Royal had net losses. During the first six months of fiscal 2001, the company's revenues were running approximately 22% ahead of the previous year's level, and the company generated a net profit during the first six months of $3.5 million (compared to a net loss of $1.5 million during the same period in fiscal 2000).

Sources: Royal Air's "Annual Information Form" and "Second Quarter 2001 Financial Statements" filed with SEDAR.

In light of the improving financial performance of the company, it may be somewhat surprising that the company agreed to a merger with Canada 3000. But even with the improved performance, which might not have been sustainable, the company was not generating sufficient cash to meet all of its financing and investing obligations. The inability or reluctance to tap the equity markets for capital, and the possible unwillingness of banks to provide the money necessary to run and grow the business, likely left Royal with little choice but to seek out a merger partner before cash ran out.

Westjet

Westjet entered the Canadian market in 1996 and has since grown rapidly and profitably. The company's business strategy is quite simple: to be Canada's leading low fare, short-haul airline. The company's primary business premise is that low fares will stimulate air travel. Westjet has targeted its fares at roughly 50% to 60% of the full fare economy fare charged by Air Canada and CAI prior to its acquisition.

During 1999, Westjet carried more than 2.3 million passengers. The company's growth strategy consists of expanding its fleet to provide increasing frequencies on existing routes and to start new routes. In March 2000, the company opened up a new base of operations at Hamilton with daily service to Thunder Bay. This represented Westjet's furthest move eastward across the country. The company has since expanded its Hamilton operations to offer the following daily, non-stop flights:

Source: Westjet flight schedule, Fall 2000.

Westjet has announced plans to commence flying out of Pearson Airport to Calgary and to continue to expand its schedule out of Hamilton. The company has no plans to start transborder flights in the next 12 to 24 months.

At this time, Westjet operates 22 B737-200s and serves 18 Canadian cities¹⁰ with about 815 weekly departures across the entire route system.

In July and August 2000, the company entered into agreements to purchase 26 B737-600 or -700 series aircraft, with options to purchase an additional 48, and to lease 10 B737-700 aircraft with options to lease an additional 10 B737-600 or -700 models. These aircraft are to be used to replace the existing fleet of B737-200s and to grow the company. Thus, Westjet may increase its fleet by up to 72 aircraft over the next eight years.

Despite significant growth in capacity during the past year, Westjet has been able to maintain load factors in excess of 65%. The company also has continued its record of strong growth in revenues, net earnings and cash flow.

Sources: Westjet "Annual Information Form" and "Third Quarter 2000 Financial Statements" filed with SEDAR.

2.4 Context: Review of the Era of Deregulation

In order to better assess the possible ramifications of opening up the Canadian market to foreign competition, it may be useful to step back and review the deregulation experience in Canada between 1984 and 1999. As we shall see, proponents of deregulation poorly predicted the outcomes because they largely ignored market realities and underestimated competitive responses. Context therefore may help in trying to forecast the future and to have realistic expectations regarding the possible consequences of opening up the Canadian airline industry further to foreign airlines and investors.

Following the Canada Transport Commission "Deregulation Hearings" in 1984, the federal government announced a new airline policy. Among the more important changes were the following:

· Any carrier could apply for and operate any route in Canada;

· Airlines could request that restrictions on existing route authorities be lifted (restrictions included flight frequency, capacity, mandatory equipment).

This policy set the stage for the deregulation of the industry in 1988 with the National Transportation Act (NTA). The Act legislated the deregulation of the civil aviation industry in southern Canada. Between 1984 and 1988 when the new NTA came into force, the airline industry underwent a dramatic restructuring and consolidation.

In 1984, there were four regional airlines¹¹ and two national airlines in Canada. But competition was not the legacy of the government's initial efforts to deregulate the industry. CP Air acquired EPA in 1984 and a majority stake in Nordair in 1985. In 1986, PWA swallowed the much larger CP Air and the new airline was renamed Canadian Airlines International. Nordair in turn acquired Quebecair in 1987 and was later fully acquired by and integrated into CAI. Hence, by the time the industry was deregulated, only one of the original regional airlines and one of the national airlines had survived.

A review of the testimony, during the "Deregulation Hearings" in 1984, will reveal that most witnesses expected a much larger number of airlines to survive and for there to be much more competition on the higher density city-pairs within Canada. Witnesses for the Competition Bureau, which favoured deregulation, argued that many new airlines would enter into this industry once the government relaxed the entry rules.

Wardair did enter into regularly scheduled service across Canada. However, Wardair's participation in this segment of the industry was short-lived as both CAI and Air Canada increased frequencies on the routes that Wardair announced it would operate and offered an increased numbers of discount fare seats on these routes. Within less than a year of its start-up of scheduled service, Wardair was taken over by CAI.

It is interesting to note that pre-deregulation in Canada, PWA flourished, especially after the demise of Transair. The company focused on its regional market - Western Canada. As well, it faced no competition from any other regional airline in that market, although it did compete in a number of markets against the two national carriers. PWA began to get into trouble after it acquired CP Air and Wardair. The company expanded beyond its niche.

As well, in the early 1980s there were too many regional carriers in Eastern Canada - Nordair, Quebecair and Eastern Provincial - for any one to be a financial success. None of these three did as well as PWA pre-deregulation. None lasted as long as PWA following deregulation.

Inter-Canadien, a regional airline in which PWA had a 35 percent interest (acquired in 1987), left the PWA family in 1989 to form the independent carrier, Intair, to compete head-to-head with both Canadian and Air Canada in the Toronto-Ottawa-Montreal triangle. Intair lasted about one year.

It was not until the mid-1990s that further attempts were made at entry into the market. Vistajet tried to emulate the Intair model and met the same fate as Intair, failing in less than one year. Greyhound set up a hub-and-spoke system based in Winnipeg. This venture also failed, although it took somewhat longer than for Vistajet. Finally, in 1996 Westjet created a Western Canada hub-and-spoke operation based in Calgary. As noted above, Westjet has not only survived, but the company has now expanded into Eastern Canada.

Westjet has succeeded where the other entrants failed because of a combination of superior management and a financially weak and poorly managed incumbent. CAI's strength in the domestic market lay in Western Canada, while Air Canada's strength was in Eastern Canada and the transborder markets. CAI could not or chose not to engage in predatory actions to drive Westjet out of the market. Air Canada, on the other hand, was much more aggressive in protecting its Eastern Canada strongholds and easily drove all entrants out of these markets.

The Canadian experience with deregulation has been quite similar to that of the US. Despite the initial euphoria that accompanied the entry of airlines such as People Express, the industry has become increasingly more concentrated with only a handful of national airlines surviving. Four of the top eight national airlines in 1978 in the US have ceased operating. Only one of the original nine local service carriers is still in business as an independent entity, but US Airways will soon be acquired by United Airlines. Moreover, very few of the many airlines to which deregulation gave birth have survived.

In the US as well, a review of the testimony during the 1976 Deregulation Hearings in the Senate will reveal that most witnesses expected a much larger number of airlines to survive and that the industry would become less concentrated over time.

Furthermore, after the passage of the Airline Deregulation Act, the commuter airline industry, which was largely independent (except for the franchised Allegheny Commuters), began to become commercial affiliates of the major US airlines. As a response to the competitive pressures presented by low-cost, new entrants, the major airlines restructured their route networks into hub-spoke systems.

In the mid-1980s, in an effort to expand the scale of their hubs and strengthen their positions at the hubs, and at the same time exit from low-density routes which could be more efficiently served with smaller capacity turboprops, the major airlines began negotiating marketing and code-sharing agreements with the commuter airlines which served the regions contiguous to the hubs. These agreements permitted greater coordination of flight schedules and increased the scale of operations at the hubs.

Several of the major carriers acquired 100% interests in some or all of their regional affiliates - American, USAir, Continental, Northwest and most recently Delta.¹² Thus, the possibility of competition by the new regional airlines developing for the national carriers has largely been eliminated.

The prevailing wisdom among economists in the late 1970s and early 1980s was that since there were no economies of scale in the airline industry, this industry was contestable (see S. 3.1 below). The economists and others who supported deregulation and espoused its "virtues" defined airline markets improperly - defining each city-pair as a distinct and separate market - and ignored the importance of integrated route networks, especially the developing hub-and-spoke networks,¹³ and overlooked the importance of the S-curve phenomenon in this industry.¹⁴ The contestability model did not apply to this industry for there are important scope economies and significant sunk costs of entry.

Supporters of deregulation also dismissed the possibility of predatory behaviour by the incumbent airlines and so did not recognize how the evolving yield management systems and the hub-and-spoke networks could be used by the major carriers to fend off new competitors in the core markets of the incumbents.

Overall, the lessons from both the Canadian and Australian experiences (see S. 4.0 below) with deregulation appear to be that small markets offer few opportunities for entry and the opportunities that exist generally involve core markets for the incumbents. Further lessons from both these countries and from the US experience as well are that the dominant carriers will protect their core markets and fight off entrants and will likely succeed because of the competitive advantages they have created. Of course, there have been a few exceptions. But wherever an incumbent has fallen by the wayside, poor management has been the critical factor. But entry has occurred in all three countries, and the market shares of low fare competitors have increased. In the US, low fare airlines have increased their aggregate market shares from just under 9% in 1986 to about 15% in 1999.¹⁵

3.0 ENTRY: THEORETICAL CONSIDERATIONS

3.1 Entry Process

Classic economic theory postulates that entry occurs in response to a profit opportunity. If market conditions change so as to yield profits in excess of appropriately risk-adjusted competitive returns, entry occurs, profits decline and entry stops when profit levels have returned to competitive levels. Entry can be either de novo entry or capacity expansion by incumbents.

Implicit in this model are the following assumptions. Entrants have information regarding the availability of supra-competitive profits and the technologies needed to participate in the industry. All entrants are equally well informed. As well, entrants have access to all of the necessary resources, including distribution channels and financial capital, at the prices at which they are available to incumbents and in the quantities that are needed.¹⁶ And no incumbent possesses a competitive advantage.

Other than being a competitively non-dynamic model,¹⁷ this model assumes that incumbents do not possess any information advantage over outsiders to the industry and says little about the rate of entry, the mix of entry (between new firms and expansion by incumbents) and the stability of the entry process.

Indeed, the assumption of perfect information makes this model inherently unstable. That is, the response to a shock that destabilizes a market equilibrium (creating profit opportunities for example) cannot, based on the assumptions and the inherent logic of the model, move the market to a new equilibrium. Once destabilized, the market becomes permanently unstable. Stability requires market power, thus dominance by a small number of companies in the industry.

A simple extension of the classic prisoners' dilemma model to a competitive market environment supports the possibility that such markets can be prone to over expansion and excess capacity when profit opportunities are perceived to exist. Indeed, hyper-competition does lead quite often to excess capacity and the ensuing adjustments can create serious problems and significant costs. We witness today excess capacity in many industries worldwide - Telecom fiberoptic networks, steel, autos, movie theaters, bookstores, etc. The adjustment process inevitably entails removing capacity from the market through consolidation and bankruptcies. Jobs are lost and site-specific (immobile) capital declines in value. Further, we have seen historic destruction in the market values of major companies stemming from the realization that there is excess capacity and hyper-competition in the telecom sector worldwide, with serious negative repercussions for consumer spending, economic growth and employment.

So in reality, the entry process may not be smooth and stable, and the adjustment process may be costly, wasteful and result in consolidation of industries, where one or two companies dominate and are able to restore some stability to investment decisions.

The theory of contestability¹⁸ was developed in the 1970s and it played a key role in supporting deregulation of the airline industry and other industries as well. By the late 1980s, it was apparent that the airline industry was not contestable in the manner postulated by the theory. City-pair markets cannot be considered in isolation of the rest of the route network; there are sizeable sunk costs; incumbents can react even more quickly than entrants from outside the industry; there are both economies of scale and scope; and incumbents do possess some competitive advantages.¹⁹

The availability of profit opportunities, real or imagined, will not ensure that entry takes place in the airline industry, or in any other industry for that matter. Incumbents will have different competitive advantages, some more sustainable than others, some more significant than others. Incumbents will be better informed than outsiders and may have site-specific or reputation advantages over outsiders. Hence, outsiders will face a number of entry barriers and all but the dominant firm in the industry will face some types of mobility barriers.²⁰

Among the many possible barriers to entry are absolute cost competitive advantages,²¹ product differentiation competitive advantages,²² reputation and access to financial capital,²³ access to inputs and distribution channels and the strategic behaviour (defensive tactics) of incumbents.²⁴

3.2 Entry Barriers in the Airline Industry

The availability of talented management heads the list of entry barriers. Without a good management team, there is unlikely to be entry, and even if entry occurs, survival is highly unlikely.

Capital comes next on the list of entry barriers. This barrier includes access to capital and the cost of capital, both of which are very much contingent on the reputation of the management team and whether or not the airline industry is in favour with investors; and on-going working capital requirements and the time required to reach the break-even point.

The next critical entry barrier is infrastructure - access to slots²⁵ (throughout the day at key airports, ability to coordinate slots at departing and arriving airports), gates and terminal space and the availability and competitiveness of secondary airports in major markets.

Flight frequencies are very important for time sensitive travelers, generally the full fare paying business passenger. The more frequencies offered on a given route, the shorter are the waiting times and so the lower the total costs of travel for these passengers. Flight frequencies affect capital and infrastructure requirements. To compete for the business traveler, an entrant must enter rapidly and on a large scale into the market. Large scale and rapid entry increase capital and infrastructure needs. But unless a prospective entrant plans to compete for the business traveler, it may not be able to attract any capital for entry. No other business model may be attractive to investors. On the other hand, given the risks inherent in any entry strategy, regardless of the quality of management, the greater the capital requirements, the more difficult it may be to raise the capital.

Market size also plays a key role in impacting the scale and speed of entry. How many markets offer scope for entry? That is, how many markets have the potential traffic necessary to support a large number of daily frequencies and generate load factors in excess of the break-even level? Related to this is how many markets can support more than one or two competitors?

Access to competitive forms of distribution (travel agents, online, in-house) is another entry barrier. The increasing popularity of distribution via the Internet is lessening the importance of this variable. So too is the improved neutrality of computer reservation systems, although biases do persist.

The ability (perceived or actual) to replicate any one or more of the competitive advantages of incumbents - route network, frequent flyer program, alliances, traffic feed, reputation, fleet size and composition, control over slots and gates, yield management systems and other information technologies, financial engineering capabilities (hedging, leasing) - or create a new advantage are important determinants of the prospect of entry. The quality of management is a critical factor, for this will be reflected in the entrant's business plan and this plan and investors' confidence in the ability of management to execute the strategies in the plan will determine if the company gets off the ground.

The investors' anticipation of the competitive responses of the incumbents also will determine whether entry takes place. Incumbents have a number of strategies, which they could select, to attack or deter entry, among them frequencies, capacity, pricing, creation of a new airline within the airline (e.g. a low cost, no frills subsidiary),²⁶ restructuring of the route network (more non-stops, more one-stop connections, aircraft types) and cost reductions.

Many of these barriers to entry are also barriers to survival of an entrant. Getting into the airline industry by itself is no assurance of financial success and survival. The US airline industry has a graveyard filled with large numbers of unsuccessful entrants.²⁷ There have been a number of failures of entrants in Canada as well.

The entry options outlined in S 2.2 above do address several of the entry barriers. The possibility of entry into the domestic Canadian market by incumbent US airlines for example,²⁸ should increase the pool of management talent. As well, these airlines should be able to access capital at competitive rates, have access to distribution channels and be able to match or improve upon the competitive advantages of incumbent Canadian airlines. On the other hand, entry by US airlines will face the same infrastructure barriers as any Canadian entrant, and there may be few markets in Canada that offer any potential for profitable entry.²⁹

Relaxing the current foreign ownership limits without changing the effective control requirements will address, at best, the capital barrier. This will do little to overcome the management barrier,³⁰ infrastructure, market size and incumbent advantage barriers.

Even though these entry options do not overcome all of the entry barriers, there is no reason to believe that any of these options will indeed accelerate the rate of entry or expand the number and/or scale of operations of entrants.

4.0 THE AUSTRALIAN EXPERIENCE

The discussion and data presented in this section of the report are based largely on interviews with industry analysts at Salomon Smith Barney Australia, Potter Warburg (a division of UBS Warburg) and Credit Suisse First Boston (CSFB), and with senior officers at Ansett, Impulse Airlines, Qantas and Virgin Blue and on research reports prepared during the past 15 months by the industry analysts.

4.1 The Early 1990s: Compass 1 & 2

Up to the end of 1990, Australia had a highly regulated airline industry. There were two domestic carriers - Australian Airlines (100% owned by the Government of Australia) and Ansett (50% owned by TNT, a private logistics corporation, and 50% owned by News Corporation) - and one designated international carrier - Qantas (100% owned by the Government of Australia). The domestic carriers did not operate any international routes and Qantas did serve a limited number of domestic trunk routes (interstate city-pairs) as part of its international services.³¹ The domestic and international markets were highly compartmentalized. However, Qantas did make large numbers of low price seats available on the last domestic leg of flights originating abroad since many of these flights used large capacity aircraft such as B747s and B767s. Qantas obviously was not a factor in the domestic business (or full fare passenger) market because it did not and could not offer many frequencies on domestic routes.

In the domestic market, interstate air services were subject to economic regulation under the Two Airlines Policy. The objective was to maintain two economically viable operators to provide trunk route services.³² The federal government controls over import licenses for aircraft ensured that the two incumbents would have roughly equal shares of the market, although the government did tolerate shifts up to 55%/45%. The federal government only controlled and hence regulated interstate routes. Intrastate routes were subject to state government controls. The Governments of New South Wales and Victoria regulated their markets, restricting entry, especially to the two domestic trunk carriers.

The major airports were owned and operated by the federal government. Ansett and Australian Airlines controlled the existing domestic terminals and gates through long-term leases. Qantas had long-term leases for the international terminals and gates, although there were common user facilities available at the international terminals for foreign carriers providing service to Australia. At Sydney and Brisbane the international terminals are geographically separate from the domestic terminals.

In October 1990, the Government of Australia deregulated the domestic market. The two incumbents were given the freedom to determine capacity, fare levels and route structures. New airlines could enter into the domestic interstate market and deregulated intrastate markets³³ as long as they qualified and received airworthiness certificates and had access to terminal space and gates. Foreign ownership restrictions were still in place at that time and Qantas was restricted from entering the domestic market beyond its current level of operations.

In 1990, the first attempt at entry into the domestic market was made. The new airline - Compass Airlines - started service along the eastern seaboard in the Melbourne-Sydney-Brisbane triangle. The venture failed within 12 months. A second attempt was made approximately 18 months after the demise of Compass 1. The new airline also assumed the name Compass Airlines and met the same fate, although it took somewhat longer.

While Compass 2 survived longer because it was better financed, economic conditions in Australia were improving and the company had more aircraft, both entry attempts failed for similar reasons. Following the collapse of Compass 1 in 1991, the Trade Practices Commission (the Australian counterpart to the Competition Bureau) concluded that aside from the competitive responses of the two incumbents, the other and more significant contributing factors for the failure of Compass Airlines were:³⁴

· The impact of the economic recession;

· Excess capacity in the Australian airline market; and most importantly,

· Shortcomings in the company's entry strategy and management.

The Commission, after investigating the incumbents' competitive responses, emphasized that they did not engage in predatory pricing. While they matched the prices offered by Compass, the Commission noted their behaviour was competitive and not a misuse of market power. Further, the non-price competitive measures - travel agent relationships and commission overrides, business lounges, frequent flyer loyalty programs, increased frequencies - were deemed to be structural features of the market.

Compass 1 & 2 also encountered other impediments. They had difficulty subleasing space at reasonable prices from the two incumbents in order to gain access to terminal space and gates. Since they were relatively undercapitalized, they began operations with between two and four old aircraft, thus making them very susceptible to aircraft failure and subsequent downtime for the airplanes and major delays and/or frequent cancellations in their flight schedules. Since punctuality and reliability are critical during the start up phase of an airline, Compass 1 & 2 were unable to overcome their initial start up problems and gain the confidence and support of the traveling public.

While the Trade Practices Commission did not find any evidence of predatory pricing or abuse of dominance by the two incumbents - Ansett and Australian Airlines - predatory behaviour (pricing, capacity and subleasing terminal space and gates) accelerated the demise of both Compass 1 & 2. Both entry attempts likely would have failed even if the two incumbents had not responded as aggressively. The lack of capital, poor management and thin domestic markets would have lead to their failure regardless.

4.2 The Year 2000: Impulse Airlines and Virgin Blue

Fast forward to the end of the 1990s, and several major changes have taken place in the Australian airline industry. Qantas was privatized in 1993 and acquired Australian Airlines in 1994, in effect creating the Australian equivalent of Air Canada. The Qantas Sales Act (1992) imposed a 49% foreign share limit for Qantas. S. 7 of this Act set out the following provisions required in Qantas' Constitution:

(1)(a) prevents foreign persons from having relevant interests of more than 49%;

(1)(aa) prevents foreign airlines from having relevant interests in total, of more than 35%; and

(1)(b) prevents any one foreign person of having a relevant interest of more than 25%.

The Australian Government introduced multiple designations in 1992, thus taking away Qantas's rights to being the sole international operator from Australia. To promote competition, the Government introduced legislation, which required the allocation of air rights to be biased against Qantas and in favour of new operators. Thus, Ansett was granted its first international route authorities and was hereafter designated as Australia's second carrier for service on international routes.

In June 1999, the Government of Australia changed the Foreign Investment Review Board Sectoral Guidelines to allow foreign-owned airlines to operate domestic-only air services.³⁵ As a result, Air New Zealand acquired 100% of Ansett Holdings in August 2000 after buying out News Corporation's 50% stake. In order to satisfy the new Guidelines, Ansett International, the operator on international routes out of Australia was spun off as a "separate" company, owned 49% by Ansett Holdings and 51% by Australian domestic institutions. But Air New Zealand has effective control over Ansett International. Ansett Domestic, which flies only within Australia, is 100% owned by Ansett Holdings and thus Air New Zealand. In August 2000, Singapore Airlines acquired a 25% stake in Air New Zealand after being thwarted in its attempts to acquire direct control of Ansett Airlines.³⁶

Singapore Airlines had acquired a 49% stake in Virgin Atlantic in December 1999. Consequently, the Brierley Group, which sold the 25% stake in Air New Zealand to Singapore, included the following "poison pill" in its agreement with Singapore Airlines: "so long as Brierley holds not less than 5% of the issued shares of Air New Zealand, Singapore Airlines will not join Sir Richard Branson or any corporation associated with him in setting up an Australian domestic airline for five years or for as long as Singapore Airlines has board representation on Air New Zealand, whichever is earlier."³⁷

The change in the Guidelines also opened the doors for Richard Branson to enter the domestic Australian market, which he did, and so Virgin Blue was created.³⁸

The privatization of the national airports made it easier for new entrants to gain access to terminal facilities and gates. Indeed, several airports developed common user terminal facilities for domestic operations. As well, the Internet became a viable distribution channel and an attractive, lower cost alternative to travel agencies.

Both Impulse Airlines and Virgin Blue announced their plans in 2000 to enter into the domestic market using jets larger than the regional jets manufactured by British Aerospace, Bombardier, Embraer and Fairchild-Dornier. The entrance of Impulse and Virgin was facilitated by the changes that took place and was clearly premised on there being scope for a low cost operator in Australia. This inherently suggests that they could establish operations with a cost base substantially lower than the incumbents to facilitate lower prices (and at the same time generate acceptable returns). While the principle is simple, as we will see below, there are some important differences to the successful models in the US.

While the change in the Guidelines opened the doors for Virgin Blue to enter the market, the reasons for Impulse's entry are more complex. Impulse Airlines was an established carrier in Australia long before the company announced its intentions to enter the domestic trunk route markets using B717s. The company was part of the Ansett family for many years, carrying out a large part of Ansett's regional airline operations along the eastern seaboard, in particular in New South Wales. In 1999, Ansett rationalized its regional service, selecting Kendell Airlines as its regional feeder and discontinuing the services provided by Impulse. Furthermore, in that same year, the Government of New South Wales deregulated the intrastate markets, which subsequently opened 17 routes previously restricted to Qantas. Consequently, Impulse Airlines' management decided to enter into the trunk route markets in order to survive the loss of its relationship with Ansett and the deregulation of its New South Wales regional market.

Virgin Blue began service at the end of August with three B737s serving Brisbane-Sydney. The company now has five B737s and flies the Brisbane-Melbourne route as well.

The company was highly sought after by several of the state governments. The Government of Queensland "succeeded" in attracting the company to establish its headquarters and principal base of operations at the airport in Brisbane. In light of Virgin Blue's recent announcements that it intends to start flying several other routes out of Brisbane to destinations such as Adelaide, Cairns and Townsville, it is apparent that the company must focus on building its Brisbane hub before it starts to fly in other city-pairs with more potential in terms of traffic.

Table 1: Domestic Passengers by City-Pairs, Australia, Year-ended June 2000

Notes: QF - Qantas; AN - Ansett; Impulse (reg.) - turboprop operations; Airlines operating on city-pairs as of April 1, 2001.

Source: Credit Suisse First Boston, research report, December 12, 2000.

For example, the Brisbane-Adelaide market ranks as the 20^th largest in Australia with approximately 210,000 passengers annually. This compares to the annual 5.4 million passengers in the Melbourne-Sydney market or the 1.4 million passengers in the Adelaide-Melbourne market. As the data in Table 1 show, Virgin Blue operates in the second and third largest markets in Australia at the present time and while the Brisbane-Cairns market also ranks among the top ten markets, there is no other Brisbane market which ranks in the top 10.

Impulse Airlines secured A$112.5 million in financing by year-end 2000 to establish and build its domestic jet operations.³⁹ This level of financing makes Impulse Airlines' entry one of the best financed new ventures to date in the airline industry worldwide. The company started operations in June 2000 with five B717s,⁴⁰ the newest generation model of the DC9 aircraft, serving Melbourne-Sydney. Brisbane-Sydney was added as the last two of these aircraft were delivered. With the arrival of its eighth B717, Impulse Airlines now provides 17 daily return trips between Melbourne and Sydney; nine daily return trips between Brisbane and Sydney; and one return trip Newcastle-Sydney-Melbourne. The company also is building up a turboprop hub at Canberra to complement its other two hubs at Sydney and Newcastle.⁴¹

Impulse announced at the beginning of March that as of April 2, it would introduce non-stop service between Hobart and Melbourne offering four daily return flights. According to Tasmanian Government officials,⁴² this announcement is the culmination of seven months of intense negotiation between Impulse and the Tasmanian Government. The government recognized that unless a third carrier was secured, Tasmanians would not experience the benefits of low-cost air travel. Tourism Tasmania facilitated Impulse's earlier than anticipated entry into the Tasmanian market.⁴³

Gerry McGowan, the CEO of Impulse, stated in the press release announcing the new service, that the airline would combine and promote its 1 am daily departure from Melbourne Airport as a joint freight/passenger service to help better cater to Tasmania's air freight needs.

Impulse Airlines initially did not pay commissions to travel agents, did not use yield management systems and did not offer any frequent flyer program. The company's unrestricted ticket prices are targeted at 50% of the Ansett/Qantas full economy fares.

Impulse and Virgin both expected to have a high reliance on their own (in-house) ticket sales via the Internet and call centre sales. The implication of this strategy is interesting. On the one hand, the new entrants' distribution costs are considerably cheaper than travel agents (commissions domestically are 5% plus overrides). However, it also suggests that the cheaper costs offset the benefits of travel agents referring business. An important consideration is whether the role of travel agents will change in the future. There has certainly been an expectation that their role will diminish following passengers' willingness to book via the Internet, but the profile of Internet users is arguably not consistent with customers seeking low cost travel.

Impulse has changed its policy with regards to travel agents and now pays commissions and overrides to selected agencies. Impulse also has purchased a yield management system and now offers a number of different fares on each flight, with the maximum fare still targeted at 50% of the full economy fares of Ansett and Qantas. The company has introduced a frequent flyer program that offers one free flight segment (one-way travel) for every 10 flights segments purchased at the unrestricted economy fare. As well, Impulse offers interlined fares linking its regional operations and jet services.

4.3 Entry Barriers

The availability of capital is near the top of the list of entry barriers.⁴⁴ Financing is available to back up a strong management team with a good business model. Impulse's management team has a good track record in regional operations and combined with the willingness of the CEO and his family to invest a significant amount of their personal wealth in the new venture were sufficient to attract investments from several major institutions. Richard Branson is personally funding the startup of Virgin Blue, with financial support from the Government of Queensland,⁴⁵ and he has assembled a competent, if not stellar, management team.⁴⁶ So both companies have been able to overcome this hurdle.

The next important entry barrier is access to airports - slots, gates, terminal facilities. Inextricably linked to obtaining sufficient slots is the frequency of flights. Flight frequency is particularly important for business passengers who value the flexibility of easily being able to catch an alternative flight to that booked, should their schedules change, without a substantial period of waiting.

Sydney is an end-point in six of the top 10 city-pairs in Australia. Slots at Sydney Airport are restricted during peak periods and there is only a limited prospect of increases in the future. Essentially any increase in capacity would require:

· A change to existing restrictions such as curfew, or the number of hourly movements permitted,

· Movement of some regional aircraft to another airport, and/or

· The use of larger aircraft in existing slots.

Both Impulse and Virgin Blue were able to get access to slots at Sydney Airport because of the rules adopted by Sydney Airport Slot Co-ordination Australia, an independent third party created in 1998 to have responsibility for the allocation of slots. There are 80 slots available per hour for all airlines operating out of Sydney.⁴⁷

Three pools were created: one for domestic and international incumbents, one for regional operations in New South Wales, and a third for new entrants. The slot allocations are split into two seasons: April-October and November-March. The initial allocation of slots in each time period is based on the principle that if the slots have been utilized historically, then the incumbents will retain those slots. The slots are not route specific and if a carrier uses a slot for less than 80% of the season, the slot is lost and goes back into the pool to be re-allocated. A new entrant pool was created by splitting all remaining slots into two additional pools - 50% for new entrants and 50% for incumbents.

This process has resulted in the following allocation of slots during the weekday peak periods (6:00 AM to 10:00 AM and 5:00 PM to 7:00 PM):⁴⁸

· 3% for the two new entrants,

· 44% for New South Wales regional flights,

· 17% for Ansett,

· 20% for Qantas, and

· 15% for international flights (including Ansett and Qantas).

At this time however, Impulse Airlines is better positioned in Sydney than Virgin Blue. Impulse has approximately two times the number of slots as does Virgin, throughout the day and in the key peak periods. Impulse's greater number of slots reflects its ability to transfer slots previously utilized by its regional operations to its trunk route operations.

The limited availability of slots in the morning and evening at Sydney airport is expected to restrict both Impulse and Virgin Blue's ability to establish a comprehensive network via Sydney and considerably reduce the attractiveness of the Australian market and the growth opportunities available. These issues will become increasingly apparent should the two new airlines try to expand their networks, with no growth possible at Sydney during these peak periods.

The problem will be particularly severe for Virgin given that Impulse has been able to convert some of its regional slots during the peak periods. The shortage of slots suggests that attracting business travelers during the key peak periods will be difficult given the low frequencies (an important service attribute demanded by the business traveler).

A further barrier to entry is that even if slots at Sydney are secured, it is important to offer slots at consistent times each day (or as near as possible); and to match slots (so that a slot for a departure from Sydney is accompanied by a slot for an arrival at Melbourne, for example, within 1½ hours). Fortunately, for the two new entrants, most airports in Australia, other than Sydney, are not subject to a cap on the number of movements per hour or to curfew restrictions. Melbourne and Brisbane continue to have excess slots available during peak periods.

Access to gates and terminals historically has been a barrier to entry in Australia. Qantas and Ansett have long-term leases until 2007 at Sydney for terminals and gates and the airport at Sydney has no Common User Terminal (CUT) to facilitate operations by start-ups. However, both Impulse and Virgin Blue have been able to secure new terminal facilities and gate access at Sydney and the new CUT at Melbourne, and have ample space at the CUT at Brisbane.

But Impulse Airlines claims that the single biggest issue the company faces at Sydney is the lack of infrastructure - the lack of a permanent terminal with a sufficient number of gates and terminal space for passengers.

The competitive advantages of incumbents and their strategic responses also have deterred or curtailed entry. Qantas, the dominant incumbent, has a number of important competitive advantages that it can use to minimize the impact of entry or to drive either Impulse or Virgin Blue or both from the important Brisbane-Sydney-Melbourne triangle.

Among the more important advantages Qantas has created are the following:

· Significant feed within its networks (partially because of the merger with Australian Airlines and the feed of its Oneworld and other code share partners);

· Largest frequent flyer, loyalty program in Australia;

· Strong distribution network;

· Superior yield management systems;

· Diverse route network and fleet (able to shift aircraft among routes and alter schedules);

· Premium product (including frequencies, frequent flyer program, connections, alliances, safety, etc.) that generates strong load factors and high yields especially in the critical first and business class sections.

According to industry analysts at CSFB and Potter Warburg, Qantas also has the best management team in the airline industry in Australia and has been much more effective than all of its competitors in hedging both fuel and currencies (particularly the US dollar). Qantas's hedging has reduced the operating cost advantages of the new entrants.

The possible strategic responses by Qantas and/or Ansett to the announcement of entry and/or to the subsequent entry by Impulse and Virgin Blue include:

· Matching fares;

· Introducing a fourth class at the rear of economy for discount travelers;

· Establishing a separate low cost subsidiary (fighting brand strategy);⁴⁹

· Accelerate cost reductions;

· Increase frequencies and capacity;

· Aggressive marketing.

It is highly unlikely that either Qantas or Ansett will set up low-cost, no frills subsidiaries. Ansett publicly has stated it is in no position to undertake such action. Industrial relations issues and restrictions on slots inhibit Qantas. Qantas may yet merge its existing regional carriers - Eastern Australian Airlines, Southern Australian Airlines, Sunstate Airlines and Airlink - to form a low cost carrier serving both regional and some trunk routes.

Neither Qantas nor Ansett is likely to create a new economy class for fear of alienating its customers. The current yield management systems, especially the one developed by Qantas, work well enough so that the two incumbents can match the low fares of the entrants without the need to reduce fares across the board. Thus, Qantas and Ansett have matched the fares of the entrants through the use of discount fares.

In addition to aggressive marketing, especially through commission overrides and expansion of frequent flyer memberships, Qantas has entered into the Newcastle-Sydney market, a stronghold of Impulse's regional operations, and greatly expanded frequencies and capacity on the Sydney to Brisbane and Melbourne routes. During the first half of fiscal 2001 (July to December 2000) Qantas increased its group capacity by 8%, more than double the average increase during the preceding four years. Load factors have been declining for Qantas for the first time in four years, excluding the impact of the Asian crisis in 1997.

Following a complaint by Impulse Airlines, the Australian Competition and Consumer Commission (ACCC), the successor to the Trade Practices Commission, concluded that Qantas did not breach trade practice laws when it expanded service to Newcastle, Brisbane and Melbourne from Sydney to compete against Impulse. The ACCC concluded that Impulse had not been harmed economically and therefore there was no reason for legal proceedings.

The ACCC concluded that Qantas:⁵⁰

· Did not specifically target Impulse's service;

· Aggressively pursued market share from Ansett;

· Added substantial capacity using high frequency jet service to accommodate business travelers;

· Charged higher prices than Impulse;

· Operated on a route that provided good yields; and

· Did not have market power on the route.

According to the ACCC, price matching is an acceptable competitive response as long as prices exceed the marginal cost of a seat. And if entrants raise fares, incumbents can maintain lower fares since the entrants have set the precedent of lower fares and must endure their own fate of discounting. For the ACCC to take any action, Qantas or Ansett would need to sell seats at prices below marginal cost, dump capacity on a route in which they have market power at a greater rate than current market growth, or re-allocate capacity from profitable routes to a route that makes lower profits to force a competitor from the latter route.

Impulse is still petitioning the ACCC to intervene to order Qantas to reduce its capacity and frequencies on the Brisbane-Sydney-Melbourne routes.

4.4 The Road Ahead

The new entrants do have a considerable cost advantage over the incumbents, primarily as a result of lower labour costs and an overall lower quality product offering. But fuel costs are much higher for the entrants⁵¹ and as the quality of their products increase so too will their respective unit costs. Impulse's booking costs have risen with the payment of commissions to travel agents. And the incumbents are searching for initiatives to reduce their operating costs. So the cost advantages are likely to decline over time.

However, even though lower unit costs (in the domestic market) can translate into lower breakeven load factors, if the entrants cannot attract loads in excess of the breakeven levels or resort to deep discounting to generate traffic and cash,⁵² then the lower costs will not translate into financial success. Incumbents generally have resorted to expanding capacity and matching fares⁵³ in other cases where entry by a new low cost airline has taken place in order to prevent the entrant from achieving loads in excess of the breakeven level. Therefore, when new entrants have lacked the financial deep pockets to withstand the competitive response by incumbents, they have usually resorted to very deep discounting of fares and shortly thereafter have failed.

Thus, low costs and low fares alone do not guarantee success.

Qantas has responded to the entry of Impulse and Virgin Blue by adopting the classic strategic responses. But the significant increase in capacity and frequencies by Qantas may be more directed at Ansett than the two entrants. Indeed, it is likely that Impulse and Virgin Blue will be caught increasingly in the crossfire between Qantas and Ansett for dominance in the domestic market in Australia.⁵⁴

Qantas views Singapore Airlines through its interest in Air New Zealand and Air New Zealand's ownership of Ansett's domestic operations as a greater long-term threat than either Impulse or Virgin Blue. Qantas believes that there is probably room at most, and limited room at best, for one additional carrier to operate in the major trunk markets.⁵⁵ So Impulse and Virgin Blue are expected to fight it out between themselves for survival and while neither may win, no other airline is expected to start up as a result and even if one of the two entrants survives, it is likely to develop a rather modest network at best.⁵⁶

Several other companies did announce their intentions to enter into the domestic market at around the same time that Richard Branson and Impulse Airlines made their announcements. Thus far, none of these other airlines (Spirit, Aussie, Skymark) has come close to start up and not one is likely to do so.⁵⁷

From Qantas's perspective, the impact of new entrants has been and is expected to continue to be, at worst, limited in terms of market shares and yields. Qantas is a different and much stronger airline competitively than when Compass 1 & 2 started in the early 1990s. Australian Airlines was one of the two incumbent domestic airlines in the early 1990s. It merged with Qantas in 1994 and the combined carrier has strong feed between the domestic and international networks, the most popular frequent flyer program and stronger distribution channels. Australian was the weaker of the two domestic incumbents; Qantas is now the number one airline domestically. Qantas has a sophisticated yield management system with which to counteract the low fare competition of the new entrants without seriously eroding its own yields. The company has more aircraft and a greater diversity of aircraft so that it is better positioned to shift aircraft around to counteract with selective increases in capacity and frequencies.⁵⁸ And in the view of Qantas, the launch of two low fare airlines is much more likely to impact the weaker incumbent, namely, Ansett. Financial market analysts concur with this view.

Nevertheless, Qantas reported a 26% drop in pre-tax profits for its domestic operations for the first half of fiscal year 2001 compared to the same period for fiscal 2000. Domestic yields deteriorated by almost 5% during this period from the average yields in the first six months of fiscal year 2000. James Strong, the outgoing CEO, said that the major impact on the domestic network was increased competition from the two new airlines, which resulted in significant price discounting and pressures on yields, especially on East Coast routes.⁵⁹ Geoff Dixon, the new CEO, has just announced plans to reduce the head count at Qantas by 1,5000 in order to control costs and remain competitive.

Ansett was in a state of uncertainty throughout much of the second half of calendar year 2000 with its ownership structure unresolved and its new management team unknown. While both issues have been resolved,⁶⁰ Ansett's management was unwilling and unable to respond as aggressively as Qantas to the entry of Impulse and Virgin Blue. Ansett lacked the aircraft, balance sheet and cash flow.⁶¹ Nevertheless, Ansett did match the lower fares introduced into the market by the entrants and extended deep discount fares throughout the domestic network.

To date, the entrants have expanded the size of the markets in which they compete by more than the new capacity they initially introduced into these markets.⁶² Their gains in market share have come primarily from Ansett. Their impact on yields also has been much greater on Ansett (approximately an 8% to 12% decline in domestic yields) than on Qantas (4% to 6% reduction in domestic yields).⁶³

Air New Zealand's financial results for the first six months of fiscal year 2001 (these results include those of Ansett Airlines) showed an even larger percentage decrease in profitability than Qantas experienced during this same period.⁶⁴ The company's after tax profits declined by almost 97% to A$3.8 million from the A$127.2 million for the six months ended December 31, 1999. The press release attributed the substantial drop in profits to significantly increased competition in the Australian domestic market, depressed demand for domestic travel in Australia during the Olympic Games period, intensifying pressures from rising fuel prices and adverse foreign exchange movements.

Expectations are for the markets to grow more slowly than additional capacity during the remainder of calendar year 2001, especially since the first half of the calendar year (second half of the fiscal year) is the weaker period and the initial euphoria over lower fares wears off. Furthermore, the battle between Qantas and Ansett will continue resulting in more capacity coming into the market and periodic price wars breaking out. The combination of slower growth, new capacity by the entrants and the war for dominance in the domestic market will put Impulse and Virgin Blue through their toughest tests to date.

Qantas has the current advantage and has been trying to capitalize on the uncertainties surrounding Ansett to take market share from Ansett. Qantas has aggressively increased capacity, primarily aimed at Ansett, but also to maintain its market share in the presence of the new entrants. Qantas has an average load factor advantage over Ansett for the entire domestic network of more than 8% points.⁶⁵ This higher average load factor is mostly prevalent during the middle of the day (load factors during peak periods are similar). Qantas's load factors are higher during the middle of the day as a result of the following:

· Qantas has larger regional and international networks and associated feed from such networks; and

· Qantas's alliance partners (Oneworld) have a greater number of services to Australia further increasing the feed advantage into the domestic network.

Qantas has been building up its frequent flyer/loyalty program membership by incorporating it with key Australian alliance partners and has competed strongly for corporate accounts. In 2000, Ansett lost the BHP corporate travel, which it held for ten years, to Qantas.

Setting aside the ownership and management uncertainties, it has been difficult for Ansett to go head-to-head with Qantas and regain market share in Australia. With limited fleet flexibility,⁶⁶ Ansett has been unable to match the increased capacity put into the market by Qantas. Thus, Qantas continues to build its advantages⁶⁷ in the important business segment of the market.

While Qantas's strategy for the remainder of this year is clear, the same cannot be said for Ansett. Gary Toomey, the new CEO of Air New Zealand, will oversee the merger of Air New Zealand and Ansett and given his finance background, he will likely strive for significant cost reductions and productivity improvements. If he focuses on cost reductions, Ansett's share of capacity in the domestic market may decline further and so too its share of the market (passengers, revenues). On the other hand, he may decide to dump capacity into the domestic market as well as the international markets⁶⁸ in order to win back market share. There is no question in aviation circles in Australia that Mr. Toomey will at some point fight back to regain market share from Qantas.⁶⁹

The entrants may be caught in the crossfire between Qantas and Ansett and consequently, one or both may fail.

Both entrants are proceeding with their plans and are increasing the size of the fleets and adding new frequencies and new routes. Virgin Blue began with two B737s, added two more by year-end and has plans to acquire an additional six by year-end 2001. Virgin Blue has announced its intention to operate the Brisbane-Adelaide route, a peculiar choice since this is the 20^th largest in Australia. But the company's Brisbane hub and agreement with the Queensland Government are the driving forces behind its choice of routes.

Impulse has just taken delivery of three new B717s, bringing its fleet to eight and expects four more deliveries later this year. While the company only started one new route (Newcastle-Sydney-Melbourne) and announced the startup of another route in April (Hobart-Melbourne), it will consider using additional aircraft to serve any of the following routes: Adelaide-Sydney, Adelaide-Melbourne, Canberra-Melbourne, Canberra-Sydney.

Although the initial hurdles required to establish a new domestic airline have been addressed successfully by both Impulse and Virgin Blue, survivability is not assured. Among the key barriers to survival are the following:

· Sufficient working capital;

· Frequency of services - critical for attracting business passengers;

· Availability of slots during peak periods to facilitate expansion/frequencies;

· Additional services such as frequent flyer programs, business lounges;

· Effective distribution channels;

· Effective yield management systems; and

· City pairs large enough to support one or more entrants.

The most critical are the latter barrier, the Qantas-Ansett battle for market dominance and the strength of the domestic economy. The airline industry is cyclical. The combination of recession, high fuel prices and a further depreciation of the Australian dollar relative to the US dollar could prove devastating for all four airlines competing in Australia, but especially for the two entrants.⁷⁰

4.5 Lessons for Canada

There are several interesting lessons. There appears to be room for two national airlines in Australia, although one is likely to end up in a very dominant position. Only one domestic airline has taken advantage of recent structural changes and market opportunities to enter into the market, and Impulse Airlines was almost forced into this strategy in order to survive. The new Foreign Ownership Guidelines did lead to the entry of Virgin Blue. But the willingness of the Queensland Government to offer concessions and financial assistance may have been even more important in attracting Richard Branson to Australia. The entry of a foreign-owned carrier has effectively blocked entry by other domestic airlines. Incumbents do respond aggressively to entry, especially when it occurs on the largest city-pair routes. And entry does lead to lower fares and yields.

But it is also important to note that successful discount operators in other countries have generally attacked the rigid hub-and-spoke networks of the incumbents to open up "new markets". In Australia on the other hand, both the geographic distribution and density of the population (particularly on the eastern seaboard with more than 65% of the population) do not support hub-and-spoke networks. Rather, a point-to-point route network is more common in Australia. A point-to-point network does not provide start-up airlines the ability to create "new markets"; rather they must go head-to-head in competition with the incumbents. Hence price, not service is the only mechanism they have available to differentiate. The Canadian domestic market is more similar to the Australian market than to the US market, although the Australian market does not have any counterpart to the transborder routes to the US.

Moreover, successful low fare airlines overseas often operate from a major city's secondary airport - arguably one of the greatest sources of cost reduction and competitive advantage. The use of a secondary airport allows the airline quicker aircraft turnaround, reduced terminal and landing costs and less congestion. In Australia there are few such opportunities available and so both Impulse and Virgin Blue have elected to utilize the same airports as the incumbents. In Canada, Hamilton Airport does provide a lower cost, less congested alternative to Pearson Airport, and thus far Westjet has taken advantage of this airport.

The other key consideration is whether the new entrants will find it worthwhile to expand services in Australia. Financial market analysts believe that the new entrants will find the market far tougher than anticipated, particularly outside of the three largest trunk routes of Melbourne-Sydney-Brisbane. In particular, if the profitability and returns are low for the new entrants, an expansion of their services would be expected to increase the risk profile/leverage of the groups without any certainty that their returns will improve with greater scale.

In Canada there are the eastern and western triangles and the trans-continental Toronto-Calgary and Toronto-Vancouver markets. So there are more opportunities, but not that many. The eastern triangle and trans-continental markets are the key domestic profit generators for Air Canada, and so Air Canada will not stand by and allow its market share to wither. The western triangle will be strongly defended by Westjet.

Every business plan allows for a given period to reach break even. However, if this point becomes sufficiently distant, irrespective of who is the backer, the willingness to fund the shortfall will cease. Both Impulse and Virgin Blue will have very large cash flow and working capital demands as they continue to grow. There is no certainty that their growth will be profitable or that their respective investment groups will be willing to contribute more money if there is no imminent prospect of sustained profitability generating acceptable returns on investment. The same is true for Canada 3000 and Roots Air. Access to the capital markets may close rapidly if profitability is not attained.⁷¹ Furthermore, as the economy weakens, new entrants will be put to their toughest tests both in Australia and Canada. The longer or the sharper the slowdown in the economy, the poorer are the prospects for survival for the new entrants.

5.0 THE US AIRLINE INDUSTRY

The discussion and data presented in this section are based largely on the annual reports, SEC filings (10k and 10Q reports) and websites of each of the airlines, as well as interviews with the Air Transport Association, Airline Pilots Association, and industry analysts at Salomon, CSFB and Merrill Lynch.

5.1 Overview of US Passenger Airlines

For this report, US passenger airlines are grouped into three categories: major airlines, niche airlines and independent regional airlines.⁷²

The major airlines group consists of the following (in alphabetical order):

· Alaska Airlines

· America West

· American

· Continental

· Delta

· Northwest

· Southwest

· TWA

· United/US Airways.

The niche airlines consist primarily of low fare airlines generally focusing on a single hub:

· AirTrans

· Frontier Airlines

· JetBlue

· Midway

· Midwest Express.

The third group consists of two of the largest remaining independent regional airlines:

· Atlantic Coast Airlines

· Mesa.

To place these airlines into perspective, Table 2 provides some comparisons. There appear to be three tiers among the major airlines, based solely on revenues - United, American and Delta comprising the top tier; Northwest, Continental and US Airways the second tier, and Southwest, TWA, America West and Alaska the third tier. The niche and independent regional airlines are about one-third and less the size of Alaska Airlines in terms of revenues and Alaska Airlines is approximately 8% the size of United.

But the United Airlines-US Airways merger and the proposed acquisition of TWA and selected assets of US Airways by American Airlines will produce four tiers with the new United Airlines and American Airlines becoming the dominant two carriers in the US, accounting for more than 45% of the entire industry. If these mergers proceed, then there may be pressure on Delta and Northwest to seek out their own merger partners. America West, Alaska Airlines and Continental are the obvious merger candidates.

Table 2: US Airlines, Selected Comparisons, Latest Fiscal Year (US$ 000s)

Sources: With the exception of JetBlue, 10K reports filed with the SEC.

The major airlines generated the highest load factors, with several being in excess of 70% system-wide. The regional airlines recorded the lowest load factors, but this was offset by the highest yields, reflecting the shorter distances flown and the relative absence of competition.⁷³

Of the major and niche airlines, only Southwest does not operate a hub-and spoke network. All of the other major airlines have multiple hubs. And most flight segments are non-stop. That is, there are few flights that are operated to a second city beyond the original destination out of the hub. Furthermore, most of the airlines have their own regional airline partners. Exceptions include Southwest, AirTran, Frontier and JetBlue.

Alaska Airlines

Alaska Air Group is a holding company that owns Alaska Airlines and Horizon Air Industries, a regional airline that operates in the Pacific Northwest, Northern California and Western Canada. Alaska serves 35 cities in six states (Alaska, Washington, Oregon, California, Nevada and Arizona), one city in Canada (Vancouver)⁷⁴ and six cities in Mexico. Based on passenger enplanements, Alaska's leading airports are Seattle, Portland, Los Angeles and Anchorage. Alaska Airlines had 13.6 million passengers during 1999.⁷⁵ The passenger load factor of 67.9% was well above the breakeven level of 59.1%.

As of year-end 1999, Alaska Airlines fleet consisted of the following 89 aircraft. On average, each of these aircraft was utilized 11.2 hours per day (based on block hours). The company also had firm orders for 23 additional aircraft.

Source: 10K report.

America West Airlines

America West operates through its principal hubs located in Phoenix and Las Vegas and a mini-hub located in Columbus, Ohio. The Airline currently offers service, with its regional airline partner Mesa to 90 destinations, including 10 destinations in Mexico and two in Canada (Vancouver and Toronto),⁷⁶ with a fleet of 123 aircraft and approximately 890 daily flights.⁷⁷

America West had 18.7 million passengers during 1999. The passenger load factor was 68.4% and the average stage lengths and passenger trips were 862 and 1,303 miles respectively.

Mesa Airlines, operating as America West Express, provides regional feeder service to and from the Phoenix hub to destinations in the Western United States and Northern Mexico flying principally regional jets and large turboprop aircraft. The expansion of the America West Express fleet of 50-passenger Canadair Regional Jets has allowed the regional operation to serve longer-range routes from Phoenix. In addition, Mesa operates America West Express regional jet service to and from the mini-hub in Columbus to Midwest and Eastern business markets. America West and America West Express currently provide the following number of non-stop destinations and daily flights at each of the three hubs:

Source: 10K report.

At year-end 1999, the America West fleet consisted of the following aircraft. On average, each of these aircraft was utilized 11.6 hours per day. The company is undergoing a fleet upgrade and expansion, with new A318s, A319s and A320s being added. Firm orders and options were placed for 77 of these models in total. The Airbus aircraft offer wider, more comfortable cabins and more first class seats than the B737s that traditionally have been the mainstay of America West's fleet. The improved in-flight services include enhanced meal service and in-flight entertainment in first class and in coach on long-haul flights.

Source: 10K report.

American Airlines

At the end of 1999, American provided scheduled jet service to more than 169 destinations throughout North America, the Caribbean, Latin America, Europe and the Pacific. American is also one of the largest scheduled air freight carriers in the world, providing a full range of freight and mail services to shippers throughout its system. American operates four hubs: Dallas/Fort Worth, Chicago O'Hare, Miami and San Juan, Puerto Rico. American did operate hubs at Nashville and Raleigh, but closed them several years ago to focus its resources on its three principal hubs on the mainland. American's acquisition of Reno Air in 1998 expanded the company's presence in markets in the Western US, but this has not lead to the creation of another hub in that region.

The American Eagle carriers, owned by AMR, the parent company of American Airlines, increase the number of markets American Airlines serves by providing connections at hubs and certain other major airports. The American Eagle carriers serve smaller markets through Boston, Dallas-Fort Worth, Chicago, Miami, San Juan, Los Angeles and New York's JFK Airport.

In December 1999, American reached a comprehensive agreement with Canadian and Air Canada to resolve outstanding issues arising from Air Canada's acquisition of Canadian. Under this agreement, American will continue to code-share on Air Canada services, which have replaced services operated by Canadian prior to its acquisition by Air Canada.

At year-end 1999, American Airlines' fleet consisted of the following aircraft. The company also had commitments to acquire 81 B737-800s and 26 B777-200s.

Source: 10K report.

Continental Airlines

Continental Airlines operates more than 2,200 flights daily to 135 US and 89 international destinations. The company has two wholly owned subsidiaries, Continental Express and Continental Micronesia (CMI), which complement its airline services. Through its Guam hub, CMI provides extensive service in the Western Pacific.

Continental operates three major hubs in the US: Newark, Houston and Cleveland. As of February 1, 2000, Continental operated 54% of the average daily jet departures (excluding regional jets) and, together with Continental Express, 58% of the total daily departures (jet, regional jet and turboprop) from Newark. Considering the three major airports serving New York City (Newark, LaGuardia and JFK), Continental and Express accounted for 22% of all daily departures, while the next largest carrier, American Airlines, and its commuter affiliate accounted for 17% of all daily departures.

Continental operated 77% of the average daily jet departures (excluding regional jets) and, together with Express, 82% of all average daily departures from Bush Intercontinental in Houston. The company together with Express operated 65% of all average daily departures from Hopkins International in Cleveland. The Houston hub is the focus of operations in Mexico and Central America. Continental flew from Houston to three cities in Canada. Continental also flies to Montreal and Toronto from its hub in Cleveland.

Source: 10K report.

Continental Airlines' jet service at each of its domestic hub cities is coordinated with Express, which operates new-generation regional jets and turboprop aircraft. Continental Express offers more than 900 daily departures to more than 90 cities from its hubs in Cleveland, Newark, and Houston. Express's regional jet and turboprop operations complement Continental's jet operations by allowing more frequent service to small cities than could be provided economically with conventional jet aircraft.

At year-end 1999, Continental Airlines' fleet (including CMI) consisted of the following aircraft:

Source: 10K report.

The aircraft were utilized an average of 10.5 hours per day. Continental also had orders and options for 110 aircraft, including B737-600/900s (65 orders and options), B757-200s (three orders), B767-400s (36 orders) and B777s (six options).

Delta Airlines

As of September 1, 2000, Delta (including its wholly owned subsidiaries Atlantic Southeast Airlines, Comair, Delta Express and Delta Shuttle) served 205 cities in 45 states in the US, the District of Columbia, Puerto Rico and the US Virgin Islands, as well as 44 cities in 28 foreign countries, including Calgary, Montreal, Toronto and Vancouver. Delta Airlines operates over 2,600 daily flights.

The Delta Shuttle provides high-frequency services between La Guardia and both Boston and Washington's Ronald Reagan National Airport. The Delta Shuttle also provides non-stop service between Boston and Reagan Airport.

Delta Express is the low-fare, leisure-oriented operation, which provides service from select cities in the Northeast and Midwest to Orlando and four other Florida destinations.⁷⁸ In October 1996, Delta Express initiated service, operating a fleet of 12 aircraft with 62 daily departures to 13 cities. Today, Delta Express operates a fleet of 40 aircraft with 168 daily flights to 21 cities.

Like the other major airlines, the Delta route network is built around four hub airports in Atlanta, Cincinnati, Dallas/Ft. Worth and Salt Lake City. These hubs also provide passengers with access to Delta's international gateway at JFK International Airport.

Similar to the other major carriers, Delta has a strong group of regional affiliates that provide additional frequencies and offer direct flights to many other cities at each of the four hubs. The Delta Connection group consists of wholly owned Atlantic Southeast Airlines and Comair,⁷⁹ and Skywest, Business Express and Atlantic Coast Airlines. Atlantic Southeast Airlines offers more than 600 flights each day from the Atlanta and Dallas/Fort Worth hub airports. Comair offers over 650 daily departures from Atlanta and Cincinnati. Skywest serves over 40 cities in 12 western states and Vancouver and Calgary out of Salt Lake City. And ACJet (Atlantic Coast Airlines), the newest Delta Connection carrier, provides regional jet service in the Northeast.

As of June 2000, Delta Airlines' fleet (excluding those of its regional subsidiaries) consisted of the following aircraft.

Source: 10K report.

Delta has entered into a long-term aircraft purchase agreement with Boeing, which covers firm orders, options and rolling options for certain aircraft through calendar year 2017. This agreement provides Delta flexibility to adjust scheduled aircraft deliveries or substitute between aircraft models and aircraft types. Delta's long-term plan is to reduce aircraft family types from seven to three.

In July 2000, ASA and Comair entered into agreements with Bombardier to purchase a total of 94 Canadair regional jets. ASA and Comair also received options to purchase an additional 406 CRJs aircraft through 2010.

Northwest Airlines

Northwest Airlines directly serves more than 150 cities in 21 countries on the continents of North America, Asia and Europe. Northwest and Northwest Airlink⁸⁰ together operate over 2,600 daily flights to nearly 250 destinations worldwide. Northwest's hub cities are Detroit, Memphis, Minneapolis and Tokyo. In the Pacific, Northwest has created one of the largest route networks concentrated at its Tokyo hub with the largest takeoff and landing slot portfolio of any US carrier at Tokyo Narita Airport. Northwest possesses "fifth freedom" rights to operate service from any gateway in Japan to points beyond Japan and carry Japanese originating passengers. Northwest is one of only two US passenger carriers that have these "fifth freedom" rights from Japan, a legacy of World War II.

In 1995, Northwest launched new services to Regina, Vancouver, Saskatoon, Montreal, Halifax and Calgary, after the US and Canadian Governments signed the "Open Skies" agreement. In 1997, Northwest initiated non-stop service between Minneapolis and Toronto.

As of September 2000, Northwest's fleet (excluding those of its regional subsidiaries) consisted of the following aircraft:

Source: Northwest Airlines website.

Northwest has orders and options for up to 160 aircraft, including 48 orders and 70 options for A319s.

Southwest Airlines

Unlike all the other major airlines, Southwest focuses principally on point-to-point, rather than hub-and-spoke, service in short haul markets with frequent, conveniently timed flights, and low fares. Southwest's average aircraft trip length in 1999 was 465 miles with an average duration of approximately 1.5 hours. At year-end 1999, Southwest served approximately 280 one-way, non-stop city pairs. In 1999, Southwest served 57.5 million passengers with an average fare of US$78.25.

Even though more long haul flights were added to the route network during the second half of the 1990s, approximately 90% of the daily departures average less than 60 minutes in flight time. The long haul flights are offered in low frequency to achieve high load factors with low fares and they complement the core high frequency, short haul, business-oriented route structure.

Southwest Airlines' top ten airports in terms of daily departures are:

Source: 10k Report.

With the addition of services to Buffalo Airport on October 8, 2000 and West Palm Beach on January 21, 2001, Southwest now flies to 58 cities throughout the US with 2,600 daily flights.

Southwest operates 332 B737-200/300/500/700 series jets as of August 8, 2000. Each aircraft is used approximately 12 hours per day. The company has 85 firm orders to purchase the 137-seat B737-700 aircraft.

TWA

As of December 31, 1999, TWA provided regularly scheduled jet service to 103 cities in the US, Mexico, Europe, the Middle East, Canada (Vancouver and Toronto) and the Caribbean. TWA's North American operations have a hub-and-spoke structure, with the primary domestic hub in St. Louis and a domestic-international gateway at JFK International Airport. TWA is the predominant carrier at St. Louis, with an average of approximately 351 scheduled daily departures in 1999 serving 83 cities. TWA had approximately a 73% share of airline passenger enplanements in St. Louis, excluding commuter flights, while the next largest competitor enplaned approximately 11%.

United Airlines

United serves 130 destinations in 26 countries and two US territories. The company provides over 2,300 daily flights throughout its network. The United Express partners serve 175 airports in the US. In November 1997, United's pilots ratified an agreement allowing United Express to operate jet aircraft with 50 seats or less.

Since October 1994, United has operated a low fare airline within an airline, United Shuttle. This subsidiary is designed to provide both affordable and profitable air service in highly competitive markets, as well as critical feed traffic. United Shuttle is principally concentrated on the West Coast and in Denver. United Shuttle offers approximately 500 daily flights on 30 routes among 22 cities in the Western United States.

United has developed five hubs in the US: Chicago, Denver, San Francisco, Los Angeles and Washington Dulles; as well as one at Tokyo Narita Airport.

Source: 10K Report.

At year-end 1999, United operated the following fleet of aircraft:

Source: 10K Report.

United also had orders for 77 aircraft and 16 options, primarily for B777s, A319s, and A320s.

In October 1999, United and Lufthansa provided up to $730 million to Air Canada to solidify Air Canada's place in the Star Alliance and to ward off the takeover bid by American Airlines and Onex Corporation.

US Airways

US Airways consist of USAir, US Airways Shuttle and MetroJet. In addition, USAir has a number of regional airline partners,⁸¹ operating as US Airways Express. US Airways, excluding the operations of US Airways Express, provided regularly scheduled service to 107 airports in the continental US, Canada, Mexico, Europe and the Caribbean at year-end 1999 and had almost 2,100 daily departures.

In 1998 US Airways purchased Shuttle Inc. from a consortium of banks. The Shuttle had flown under the US Airways name since 1992, when US Airways became an investor with a minority ownership stake. US Airways Shuttle flies between LaGuardia and Reagan and Boston Airports and also between Reagan and Boston.

MetroJet was started in June 1998 in response to the entry of low cost carriers (Southwest, AirTran, Delta Express) into the Eastern US markets where USAir had 85% of its system wide departures and 57% of its capacity measured in available seat miles. Fares were generally set 50% to 65% below the full economy fares prior to entry into the selected markets. This subsidiary began with five B737-200s and expanded to 42 aircraft offering 22 daily departures and serving 22 cities. Metrojet has been most successful in the Washington, Boston and Florida markets.

US Airways Express is made up of nine regional air carriers that fly to smaller communities throughout the US Airways system. With more than 2,500 daily flights and service to 163 airports, US Airways Express is in itself one of the world's largest airline systems.

US Airways has its principal hubs at Charlotte, Philadelphia and Pittsburgh and substantial operations at Baltimore/Washington Airport, Boston, LaGuardia and Reagan Airports.

Source: 10K Report.

By mid-year 2000, US Airways operated the following fleet (excluding the fleet of US Airways Express):

Source: USAirways website.

AirTran Airways

AirTran, the product of the merger between ValuJet and AirTran in 1997, provides daily scheduled jet service to 34 destinations. The company operates 310 daily departures system wide with 137 daily departures at its Atlanta hub. AirTran flies to Buffalo, Akron, Toledo, Flint and Minneapolis - the US destinations closest to the Canadian border. But with the exception of two routes, all routes are non-stop spokes out of Atlanta or Chicago Midway with no continuing service beyond the original destination.

The company has 54 aircraft - 35 DC9-30s, 15 B717-200s and four B737-200s. The company was the launch customer for the B717 and will replace the DC9s with these aircraft since they burn 23% less fuel per hour than the DC9s and with 60% fewer parts in the environmental, avionics and electrical systems, maintenance and inventory costs are significantly lower.

Frontier Airlines

Frontier Airlines commenced operations on July 5, 1994. The airline took advantage of three unique windows of opportunity:

· A major airline's dramatic downsizing of its Denver operations, leaving service gaps in various major markets;

· The construction of Denver International Airport, which replaced the heavily congested Stapleton Airport; and

· The availability of several key executives from the former Frontier Airlines, who created a senior management team with long-term experience in the Denver market.

Frontier is a low-fare, full service airline and is the second largest jet service carrier at Denver International Airport with an average of 118 daily system-wide departures. Frontier operates a hub-and-spoke system from Denver. Including Denver, the airline currently serves 24 cities in 18 states. The closest Frontier gets to Canada is at Seattle, Portland (Oregon), Chicago Midway and Bloomington-Normal (Indiana). The airline's average stage and trip lengths are 863 and 905 miles respectively, indicating that most of the traffic is point-to-point with Denver as one end-point.

Frontier flew 2.3 million passengers in the fiscal year ended March 30, 2000 and has approximately a 7% market share at Denver. United and its regional airline affiliates have an aggregate market share of about 72%.⁸²

Frontier currently operates a fleet of eighteen 136-passenger B737-300s and seven 109 seat B737-200s. These aircraft are utilized just under 10 hours per day. In March 2000, the company entered into an agreement to purchase six A319s and five A318s, with options to purchase an additional nine aircraft. The order contemplates a fleet replacement that will phase out the B737s over four to five years and replace them with the A318s and A319s.

JetBlue Airways

In September 1999, JetBlue received approval for 75 take-off and landing slots at JFK Airport. JetBlue took to the air on February 11, 2000 when it inaugurated its first flights to Fort Lauderdale and Buffalo from JFK, which serves as its hub. By the end of the year, the airline served 12 cities with a fleet of 10 new A320 aircraft.

JetBlue reported that August, only its sixth full month of operation, was its first profitable month. The company currently operates 58 flights a day. In 2001, the company will double the size of its fleet as it takes delivery of 10 more A320s and will add more new cities to its list of destinations.

From New York's JFK Airport, the airline flies five times daily to Buffalo; four times daily to Rochester, and Fort Lauderdale; three times daily to Orlando and Tampa; twice daily to Burlington (Vermont) and West Palm Beach; and daily to Los Angeles/Ontario, Oakland, Salt Lake City and Fort Myers.

The airline was started by David Neeleman who sold his first airline, the Salt-Lake City based Morris Air, to Southwest Airlines. Following the sale of Morris Air, Neeleman went on to help launch WestJet. In July 1999, with his management team,⁸³ he raised US$130 million in equity from investors such as Weston Presidio Capital, George Soros and Chase Capital. JetBlue recently raised an additional US$30 million in equity capital from existing JetBlue shareholders. This new transaction brings the total equity committed to JetBlue to US$160 million, by far the most raised by a start-up airline in US aviation history. Neeleman placed a US$4 billion order in April 1999 with Airbus for up to 75 A320 aircraft.

Neeleman had originally hoped to start an American version of Virgin Atlantic Airways, but when negotiations with Richard Branson fell through, he signed on Virgin's marketing executives and proceeded to create the airline on his own.

Midway Airlines

Midway shifted its base of operations from Chicago Midway Airport to Raleigh-Durham in March 1995 following American Airlines closing down its Raleigh hub. The company provides non-stop service from its Raleigh hub to 22 cities in 13 states and the District of Columbia. In November 2000, Midway inaugurated its first non-stop transcontinental service between Raleigh and San Jose. Among the other destinations are Buffalo and Rochester - the closest to Canada. All flights are direct city-pairs without a second leg. The average stage length is just under 500 miles and the average fare is US$ 103.

Midway's regional partner, Corporate Airlines, provides non-stop turboprop service to an additional seven cities from Raleigh. Midway and its regional partner operate 250 daily flights from the Raleigh hub.

The company, as a result of taking over the Raleigh hub, maintains a significant relationship with American Airlines. Midway contracts with American for services such as yield management and ground handling.

As of the end of March 2000, Midway operated a fleet consisting of eight 98-seat Fokker 100s, 20 50-seat CRJs and two 128-seat B737-700s. These aircraft are utilized 8.6 hours per day on average. The company has firm orders for six additional CRJs to be delivered by December 2001 and options to acquire up to 14 more, and firm orders for 15 B737-700s to be delivered by October 2002. The additional aircraft will be utilized to replace some or all of the F100s, to serve existing Midway destinations with greater frequency, and to enter new routes, providing Midway's customers with more non-stop jet destinations.

Midway finds that the CRJs enable it to expand the depth and breadth of services - adding service to new cities and increasing frequencies on existing routes. The increased frequencies per market offer passengers a larger number of flight options and greater flight time convenience (both of which are important for business travelers).

Midwest Express

Midwest Express operates a single-class, premium service passenger jet airline that caters to business travelers and serves major destinations throughout the US from its principal hub in Milwaukee and secondary hubs in Omaha and Kansas City. The company has the largest market share of passengers at Milwaukee. In 1999, Midwest Express carried 35% of the passengers boarded in Milwaukee, while Northwest Airlines had a market share of 21%. In 1999, Midwest carried 6% of the passengers boarded in Omaha compared to 24% boarded by United Airlines and 15% by Southwest Airlines.

Skyway Airlines, the wholly owned regional airline subsidiary serves 28 cities in the upper Midwest, providing connections throughout the Midwest Express and Skyway systems, and point-to-point service between select markets. Midwest and Skyway provide service to Toronto from each of the three hubs.

Midwest Express had tried to develop Indianapolis as its third hub, but decided towards the end of 2000 to shut down its Indianapolis operations and shift the resources to Kansas City, which is to become the third base of operations. To buttress the Kansas City hub, Midwest entered into a code-sharing relationship with Air Midwest, a Mesa Air Group subsidiary, to provide connecting service between Kansas City and 14 Midwestern cities.

The company currently operates the following fleet, which is utilized an average of 8.8 hours per day:

Source: Midwest Express website.

Atlantic Coast Airlines

Atlantic Coast Airlines has code-sharing and marketing agreements with United Airlines and Delta Airlines. In its United Express operations, the company offers 249 daily flights to 44 destinations at Dulles and 42 daily departures to 14 destinations at Chicago. An increasing number of routes are using regional jets. The top five airports based on frequency of operations are Washington-Dulles, Chicago O'Hare, JFK, Newark, and Raleigh. The company operates a classic hub-and-spoke network at both Dulles and Chicago, with all flights being non-stop with no second leg.

In 1999, Atlantic Coast carried 3.2 million passengers with an average trip length of 320 miles and an average fare of US$ 106.

Atlantic Coast Jet (ACJet), based at LaGuardia, is a Delta Connection carrier. This division began service in August 2000 and currently serves five cities out of LaGuardia.

Atlantic Coast (ACA) reached an agreement at the end of November 2000 with United Airlines on a new 10-year contract that increases the total number of regional jets it will operate within the United Express program, and amends the financial relationship between the two companies. Under the terms of the new agreement, ACA/United Express will increase its number of regional jets to 108 by the end of 2003 from the 34 CRJs ACA currently operates as part of the United Express program. As part of the new agreement, the financial structure of the relationship between ACA and United will change from a pro-rate contract to a fee-per-departure arrangement. This insures that Atlantic Coast will receive a fee from United for each departure completed by ACA. The fee-per-departure arrangement is structured to mitigate earnings volatility due to external factors such as fuel and passenger yields. United will take full control of seat inventory, as well as complete responsibility for selection of destinations and schedules served by all ACA aircraft.

The agreement limits the ability of ACA to merge with another company or dispose of certain assets or aircraft without offering United a right of first refusal to acquire the company or assets and provides United a right to terminate the agreement if ACA merges with or is controlled or acquired by another carrier.

The agreement with Delta also has a fee-per-departure structure; whereby, the company is contractually obligated to operate the flight schedule for which Delta pays ACA an agreed amount regardless of passenger revenues. The agreement also restricts the ability of ACA to dispose of aircraft without offering Delta a right of first refusal to acquire such aircraft.

At the end of 2000, Atlantic Coast Airlines had a fleet consisting of 31 CRJs, seven 328FRJs and 60 Jetstream turboprops. The company had firm orders for 35 CRJs and options for an additional 27. As well, ACA had firm orders for 18 328FRJs and options for a combination of 55 328FRJs and 428FRJs. The company believes that the future of the regional airline industry lies in utilizing regional jets to complement and feed the major carriers.

Mesa Airlines

Mesa Airline serves 134 cities in 38 states, the District of Columbia, Toronto, and Guaymas and Hermasillo in Mexico with approximately 1,100 daily departures. In 1999, the company carried 4.3 million passengers. The average stage length was 225 miles and average trip length and fare were 311 miles and US$ 94.

Mesa's airline operations are conducted by three regional airlines utilizing hub-and-spoke systems. Mesa Airlines, a wholly owned subsidiary of Mesa Air Group, operates as America West Express under a code sharing agreement with America West Airlines; as US Airways Express under code-sharing agreements with US Airways; and also operates an independent division, Mesa Airlines, from a hub in Albuquerque. Air Midwest, another wholly owned subsidiary, operates under a code-sharing agreement with US Airways and flies as US Airways Express. CCAIR, which was acquired during fiscal 1999, also operates under a code-share agreement with US Airways.

Mesa's subsidiaries have one code-sharing agreement with America West (operating out of the Phoenix and Columbus hubs) and five separate code-sharing agreements with US Airways (Kansas City; Pittsburgh; Charlotte and Raleigh; Philadelphia, New Orleans, Orlando and Reagan Airports; and a regional jet service). The code-sharing agreements provide for terms of five years for America West (expiring in 2004), and from one to seven years for US Airways.

Mesa Airlines had a fleet of 140 aircraft at year-end 1999 consisting of 29 CRJs and 111 turboprops.

5.2 Airline Strategies

In reviewing the stated strategies of the US carriers described above, the similarities stand out. All of the airlines are focusing on the business traveler - the so-called "road warrior" who accounts for 10% to 15% of all passengers and can account for more than 60% of all passenger revenues.

Table 3: Code-Sharing, Marketing and Other Alliance Partners⁸⁴

Sources: Annual Reports, 10K Reports, company websites.

To attract more of these customers, all airlines are intent to further build up their hubs - offering more frequencies and destinations; enter into more alliances and code-share agreements to expand their global reach; and improve the level of service provided. In addition to the domestic links, most of the US airlines have a number of agreements with foreign carriers.

Among the US airlines reviewed in this report, only Southwest, AirTran and JetBlue do not have any type of link with another US carrier.

Interestingly, just as there are now four major computer reservation systems worldwide,⁸⁵ the latest round of consolidation in the US industry suggests that there similarly may be only four major worldwide alliances within the next few years. There are currently five such alliances, but the SAir Group (Swissair) does not have a close link with a major US carrier.

Alaska Airlines

Alaska Airlines is concentrating on expanding the number of alliances it has in place with other airlines. The purpose of the alliances is to enhance Alaska's revenues by

· Providing customers more value by offering them more travel destinations and better mileage accrual/redemption opportunities,

· Gaining access to more connecting traffic from other airlines, and

· Providing members of alliance partners' frequent flyer programs an opportunity to travel on Alaska and Horizon while earning mileage credit in the alliance partners' program.

America West Airlines

The principal objectives of the company's strategy are the following:

· Grow the airline,

· Improve yields,

· Maintain its cost advantage,

· Ensure financial flexibility for the future, and

· Pursue strategic e-commerce opportunities in the travel and travel-related industries.

The Company intends to achieve these objectives by increasing service to and from its three hubs.⁸⁶ As well, America West will increase the number of code-sharing arrangements. These alliances allow the airline to expand its passenger base without significant increases in capital or operating expense and in some cases, achieve cost savings through economies of scale and joint purchasing agreements. The company believes that alliances are an efficient means of developing new markets and increasing travel opportunities for its customers.

To improve yields, the company is going to target business markets in further developing its route network; pursue more corporate accounts; invest in the latest generation, yield management system;⁸⁷ and improve the quality of its product, including a more attractive frequent flyer program⁸⁸ and improved on-time performance.

American

American intends to build upon its competitive advantages relative to its domestic competition. It has a comprehensive domestic and international route structure, anchored by efficient hubs and numerous alliances, which permit it to take full advantage of whatever traffic growth occurs. The company's AAdvantage frequent flyer program is the largest program in the industry.

American will continue to expand the depth and breadth of its alliances. It will continue to maintain a fuel efficient and diverse fleet though ongoing fleet replacement and growth. A new contract with the pilots will allow the AMR Eagle subsidiaries to expand the regional jet fleet in order to be more competitive with the other regional airlines and to increase the frequencies provided and destinations served by these subsidiaries. These moves will strengthen the major hubs.

To improve the quality of its product, the company has undertaken two important initiatives:

· American plans to restructure flights at its Chicago hub to isolate this hub from the rest of the network. Flights from Chicago will return to Chicago rather than continue beyond the original destination. This will build a firewall between the Chicago operations and the rest of the network and should reduce the spread of flight delays stemming from weather and other traffic problems at Chicago. To reduce delays at Dallas-Fort Worth, American will reduce the rate of aircraft arrivals and departures throughout the day at this hub and elongate block and ground times.

· Beginning in February 2000, the company announced a new program to provide more room for passengers throughout its coach cabins. American's entire fleet will be reconfigured to increase the seat pitch for more than 75,000 coach seats.

Finally, to increase the size of its network and operations and gain access to new hubs (one domestic and one a gateway to Europe), American has an offer to buy TWA.

Continental

The company has set out the following strategic plan:

· Pursue business travelers,

· Expand international alliances,

· Develop further its hub franchises,

· Improve its financial flexibility, and

· Make reliability a reality.

Continental intends to increase the revenues generated out of its three principal hubs by 50% over the next five years. To do so, it is adding large numbers of new destinations at each of the hubs.⁸⁹ Many of the destinations will be in Europe, the Caribbean, Mexico and Latin America. As well, the company is considering starting a high-speed train connection from Newark to Penn Station in New York and to many cities within a two-hour train ride of Newark.

To improve reliability, Continental has spread out arrival and departure times at Newark - its most delay prone hub. Customer service in general will be a principal focus.

Continental will develop new alliance relationships that complement its own flying and permit expanded service through Newark and Houston to major international destinations.

Delta Airlines

Delta will focus on developing new international routes, especially to Europe and Latin America; fleet streamlining and expansion through its remaining 17-year agreement with Boeing; IT investments in yield management, distribution and strategic sourcing through a B2B site; and the expansion of its new Skyteam alliance to match the scale and scope of the Star and Oneworld alliances.

If American does succeed in acquiring TWA, Delta will look to merge with any one of America West, Continental or Northwest so as to not become a distant third in the US market and internationally.

Northwest

Northwest has been overhauling its domestic and international route system to focus on profitable flying and on its strategic assets. Most non-hub domestic routes (including "mini-hub" schedules at Washington and Milwaukee) have been abandoned to shift resources into hub flying, and the Seoul hub is being downsized. Service to Australia was terminated to allow greater focus on Japan. Non-strategic, trans-Atlantic routes will be suspended to allow more trans-Atlantic flying from hubs, particularly Detroit and Amsterdam. Northwest is investing billions of dollars to expand its terminal facilities in Detroit and Memphis.

The company also intends to expand the scope of its major alliances with Continental and KLM. Further, Northwest is the only US passenger airline to operate a dedicated freighter fleet (10 B747s to increase to 12 in 2001) and is one the world's largest cargo airlines. The company plans to expand its cargo business by increasing its fleet and expanding its alliances in the Pacific region where it derives 70% of its cargo revenues.⁹⁰

Southwest

Southwest's scheduling strategy includes careful airport selection in order to avoid congested, slot constrained and hub airports. By operating out of conveniently located satellite or downtown airports,⁹¹ the company avoids delays, thus minimizing passengers' total travel time, minimizing turnaround times for aircraft and maximizing the utilization of aircraft and gates. The company will continue to focus on point-to-point service and avoid a hub-and-spoke operation and alliances.

Since the company serves only 58 cities at present and has about 8% of the domestic market, it intends to continue growing its fleet and network. Management believes there are ample opportunities for growth in the US market for its type of service and product.

United Airlines

The key aspect of United's strategy going forward is to merge US Airways into its operations. Unlike previous airline mergers dating back to the 1980s, United and US Airways do not share a common hub. The merger brings together two complementary route systems that will result in a greatly expanded network that will connect US Airways' Eastern US routes with United's Western US routes and international network. Consumers will be provided with more convenience and more travel options to more places in the US and around the world.

For example, United will strengthen Charlotte's competitive position as a hub in the Southeastern US. United plans to provide non-stop or one-stop service from Charlotte to 215 cities in the US, Canada and Mexico as well as to 34 other international destinations. Altogether, United has proposed 25 new international non-stops from Boston, JFK, Philadelphia, Denver, Dulles and Charlotte, and 64 new US non-stop flights, primarily across the continent.

In addition to the acquisition of US Airways, United set out a strategy to improve profitability:

· Rebuild the company's infrastructure, simplify and upgrade the fleet;

· Grow profitably by focusing on the existing hubs and by further developing the global network;

· Improve the quality of the product; and

· Repair and reshape the company's labor relations.

Besides offering convenient scheduling throughout its domestic and international segments, United is seeking, like its competitors, to attract high yield customers and create customer preference by providing a comprehensive network, an attractive frequent-flyer program, and enhanced service initiatives.

To expand its hub operations, United's regional airline partners operating as United Express, are now able to greatly expand the regional jet fleet as a result of the contract between United and its pilots and are using these new aircraft and the easing of high-density rules at Chicago O'Hare to add flights to a number of small and medium-sized communities. Passenger feed into the system from small city markets is critical to the efficient operation of the company's network. United also is looking to further increase its code-sharing alliances, which are in addition to the partners in the Star Alliance.

As well, United announced in August 1999 the reconfiguration of the first six to eleven rows of the economy cabins in its aircraft serving the domestic market, thereby providing four to five additional inches of legroom for customers sitting in the reconfigured rows. This initiative is designed to serve as recognition for United's Premier frequent-flyer and full-fare economy customers, and to increase their satisfaction with United.

Finally, United launched a premium express product - TD.Guaranteed - targeted to customers who need highly reliable, time definite shipments. The company also improved facilities at three cargo stations - Miami (gateway to Latin America), Los Angeles and Dallas-Fort Worth.

AirTran Airlines

The company's strategic goals are to strengthen its hub operations by restructuring the connecting banks in Atlanta; enter new markets (add new spokes from the hub) that offer attractive returns; and improve customer service. Part of the plan to improve customer service includes adding a Business Class section and developing a rewards program. While these various strategies and actions are aimed at attracting more business travelers, the company also is actively pursuing corporate travel accounts in the Atlanta and Southeastern US regions.

Frontier

Frontier's business strategy can be described succinctly as follows: provide air service at affordable fares to high volume markets from the Denver hub. The strategy is based on the following factors:

· Stimulate demand by offering a combination of low fares, quality service and frequent flyer credits in Continental Airlines' OnePass program;

· Expand the Denver hub operation and increase connecting traffic by adding additional high volume markets; and

· Continue filling gaps in flight frequencies to high volume markets from the Denver hub.

The company's sales efforts are targeted to price-sensitive passengers in both the leisure and corporate travel markets. Frontier offers all of its seats at various discount fares, cutting the cost of travel in its markets by as much as 60%. Unlike most other airlines, passengers are not required to stay over a Saturday night prior to their return trips in order to qualify for the low fares. Frontier also offers a corporate discount program to small, medium and large businesses.

The company is expanding and upgrading its fleet to reduce operating costs and improve the quality of its service.

Midway Airlines

The principal elements of the Company's operating strategy are:

· Attract high-yielding, local business travelers. To attract these passengers, the Company has designed its operations to serve the needs of business travelers flying to and from Raleigh-Durham. The Company has developed relationships with major corporations located in the Raleigh-Durham area, and offers these business travelers frequent non-stop jet service, as well as a high quality, in-flight product and AAdvantage frequent flyer miles.

· Maintain high quality operations.

· Continue to reduce operating costs by expanding the scale of the Raleigh hub and acquiring new aircraft, including regional jets.

The company believe that Raleigh remains relatively under-served with respect to non-stop flights and that this hub can serve as a convenient connecting point for East Coast leisure and some business travelers.

The principal elements of the Company's growth strategy are:

· Increase frequencies to current markets;⁹²

· Increase number of markets served;

· Maximize connecting opportunities.

To capitalize on the support it receives as the "hometown" airline, Midway offers discounts to several corporations in exchange for a premium share of their travel. Employees of some of these corporations also are offered discounts for leisure weekend travel on flights that would otherwise operate with empty seats. The program, called "Midway Weekend Madness", has helped build loyalty in the Raleigh-Durham market.

Midwest Express

Midwest Express caters to business travelers and has built its reputation by providing premium service. The company operates a frequent flyer program under which mileage credits are earned by flying on Midwest Express, Skyway or other participating airlines (including Swissair, Virgin Atlantic and Northwest). The company's frequent flyer program includes a marketing agreement whereby members in Northwest Airlines' WorldPerks Frequent Flyer Program and Midwest Express program members maintain their separate accounts, but can redeem award travel on either carrier.

The most important strategic initiative has been the creation of a third base of operations at Kansas City and the transfer of flight operations from Indianapolis to Kansas City. The company has targeted the Midwest and under-served cities in this region for the hub bases.

Atlantic Coast Airlines

The company continues to capitalize on and grow its identity with United. In addition, ACA entered into a new relationship with Delta Airlines to create ACJet. Overall, the company sees that its future lies in utilizing regional jets to complement and feed the major carriers. These aircraft are being used to complement the turboprop route system by initiating service from Washington-Dulles to markets beyond the economic operating range of turboprop aircraft and they have been selectively deployed in the short-haul, high-density East Coast markets. The company also has utilized the CRJs to begin a second hub operation at United's Chicago-O'Hare hub and for the ACJet services.

The company also believes that multiple marketing agreements will enable it to reduce reliance on any one major airline.

Mesa Air Group

The key characteristics of the regional airline market include:

· Relationships with major airlines, operating feeder service to hubs for connecting passengers under code-sharing arrangements;

· Allocation of new-generation regional jet aircraft to routes that were traditionally larger jet routes;

· Service in low-density markets which remain unattractive to major airlines and low-fare carriers; and

· Ability to provide complementary service in existing major airline markets by operating flights in scheduling gaps between those of the major air carriers.

Accordingly, the company's long-term business strategy is to operate a high-frequency, quality-service airline, primarily with a hub-and-spoke route system. Mesa believes its code-sharing agreements provide a significant competitive advantage in hub airports where its major partner has a predominant share of the market. The ability to control connecting passenger traffic by offering a superior service makes it very difficult for other regional airlines to compete at such hubs.

5.3 Lessons for Canada

There has been a steady, if not spectacular growth in the aggregate market shares of low-cost, low fare airlines in the US from 8.8% in 1986 to just over 15% in 1999. Much of the gain reflects the continued success and growth of Southwest Airlines. Many entrants have failed and continue to do so. As pointed out by Michael Boyd, an airline industry consultant, the failure of the start-ups post 1997 is largely attributable to poor management, weak business plans (including the introduction of scheduled service into geographic markets where no market existed and inferior product offerings) and inadequate financing.⁹³ But entry continues, with de novo entry by JetBlue and expansion by Southwest, AirTran, Frontier and Midway.

Perhaps, there is an upper limit to the aggregate market shares of low-cost airlines in the US and elsewhere. But the market share may be sufficient to provide competitive pressures on fares in many domestic markets.

However, just as entry is a characteristic of the US market, so too is consolidation. ValuJet was merged into AirTran in 1997. American acquired Reno Air and AMR Eagle bought out Business Express in 1998. Delta acquired Atlantic Southeast and Comair in 1999. United is in the process of taking over US Airways, and American has an offer to buy TWA and selected US Airway assets (accounting for approximately 20% of USAir's traffic).

Consolidation is spurred by the desire to continually increase the scope and scale of the route networks. With the exception of Southwest Airlines, the major US carriers have concentrated on building up the feed through and the size and number of their hubs. This has been an important component of their strategic responses to competition and of their focus on the business traveler. Fortress hubs reduce the competitive impacts of entry and provide a basis for resorting to capacity, flight frequency, scheduling, frequent flyer programs, travel agent commission overrides and alliances for attacking new competitors.

As part of the strategy to strengthen their hub operations, the major airlines have developed close relationships with regional airline partners. Indeed, the regional airline industry in the US has been dramatically transformed. Trans State Airlines will soon be the only significant regional airline in the US without a feeder relationship with a major airline.

The introduction and increasing role of regional jets⁹⁴ have expanded the role of regional airline partners/subsidiaries and their importance in the hub-and-spoke networks of the major airlines. Regional jets have become very important in the on-going development of hubs by the major airlines and one of the niche airlines. Regional jets operated by the regional airline affiliates serve the following number of spokes at each of the major hubs:

· America West: Phoenix - 15; Columbus - 12

· American: Chicago - 35; Dallas - 30

· Continental: Houston - 39; Cleveland - 37; Newark - 23

· Delta: Cincinnati - 79; Atlanta - 46; Salt Lake City - 25

· Midwest Express: Milwaukee - 10

· Northwest: Detroit - 25; Memphis - 25; Minneapolis - 24

· United: Dulles - 31; Chicago - 22; Denver - 21.

Frequency is easier to provide with regional jets than narrow-body jets and they have proved quite attractive (financially and competitively) for entering or starting new markets. US regional airlines, operating the small regional jets on new nonstop routes, have extended the geographic reach of the major hubs, augmented the larger jet operations at off-peak hours, and replaced the major airlines' larger jets on thin routes. The new services carry a very high proportion of business travelers.

In addition to expanding the operations of regional airline partners, three of the major airlines (United, USAir and Delta) also have created a low-cost, low fare airline within the airline. In order to start these new airlines, the major carriers obtained wage and productivity concessions from their employees. United Shuttle's initial point-to-point route structure was quickly dismantled and replaced by a feed network into Los Angeles and San Francisco. MetroJet's route network has been repeatedly changed and its growth scaled back. Even Delta Express has had mixed results thus far. While the original intent of all of these new airlines was to use them as fighting brands against low cost carriers such as Southwest and AirTran, this strategy has not been entirely successful, and the parent companies periodically experiment with their route structures and roles.

Finally, it is worth highlighting that the US Congress has passed legislation increasing the availability of slots at all four high-density airports - LaGuardia, JFK, O'Hare and Reagan. Under the new legislation, slot restrictions at O'Hare Airport will be limited to the hours between 2:45 p.m. and 8:14 p.m. after July 1, 2001 and all slot restrictions are to be abolished after July 1, 2002. At the New York airports, slot restrictions are to be abolished after January 1, 2007.

The rules also provide that, in addition to those slots currently held by carriers, operators of regional jet aircraft may apply for, and the Secretary of Transportation must grant, additional slots at Chicago, LaGuardia. JFK and Reagan in order to permit the carriers to offer new service, increase existing service or upgrade to regional jet service in qualifying smaller communities. There is no limit on the number of slots a carrier may request for these purposes.

These initiatives have created problems. The demand for additional slots at LaGuardia and the number of new services that were initiated (involving about 300 additional takeoffs and landings per day) overwhelmed the airport, increasing delays to well over 20% of all scheduled flights. As a result, the federal government has ordered reductions in flights at LaGuardia beginning at the end of January 2001. The flight reductions are to remain in place until September.

6.0 CANADIAN CARGO MARKET

The air cargo industry can be segmented as follows:

· Belly freight on passenger aircraft;

· Overnight freight (express documents and small packages, express heavy freight);

· International air cargo.

Dedicated freighters are used only in the latter two segments. Competition in Canada in these two segments can be characterized largely as follows with the principal foreign carrier and its Canadian partner in the Canadian market:

· Small packages:

· Purolator/CPC - Kelowna;

· FedEx - Morningstar;

· UPS, DHL - All Canada Express;

· Loomis - Royal, All Canada Express;

· Sameday Rightoway - Royal, All Canada Express;

· Heavy freight:

· BAX Global - All Canada Express;

· Emery - ICC Cargo.

For example, FedEx operates between its hub in Memphis and each of Toronto, Montreal and Vancouver. Morningstar operates on behalf of FedEx carrying small packages between Canadian cities including these three.

There has been very rapid growth in the Canadian market during the past decade as measured by the number of dedicated jet freighters in operation:⁹⁵

· Domestic:

· 1989: 2 B727s

· 2000: 24 B727s, 3 B737s

· Transborder:

· 1989: 3 B727s, 1 DC8

· 2000: 12 B727s, 5 B757s, 3 A310s, 3 A300s

In 1989, six jet freighters were used to serve the Canadian market. By the year 2000, 50 jet freighters we re employed nightly to service Canada. But the Canadian industry continues to pale in comparison with the US industry.

The major Canadian companies involved in the air cargo industry, other than Air Canada and to a lesser extent Westjet, are the following:

Source: see footnote 95.

The Canadian freight carriers are each and collectively a fraction of the size of the major US freight carriers. FedEx has a fleet in excess of 660 aircraft and revenues exceeding US$15 billion; UPS operates with more than 260 aircraft and has revenues of US$27 billion. Other major players in the cargo industry include: Lufthansa Cargo, Northwest Cargo, United Cargo, Nippon Cargo Airlines, Emery Worldwide, Evergreen International and DHL. No Canadian company comes close to ranking among the top 25 biggest cargo carriers.

Since the cargo sector is being shaped by the trends toward globalism, intermodalism, e-business and logistics, some blurring of express services and cargo is anticipated. Global Aviation Associates believes,⁹⁶ in the wake of the acquisition of DHL by Deutsche Post and the recent agreement between the US Postal Service and FedEx, that consolidation of the cargo industry will produce a small number of principal operators with a much larger number of specialist companies serving the principal companies and/or niches in the marketplace.

Further, the US hub and spoke networks do not work across Canada. The Canadian companies operate linear, multiple stop networks across the country.

According to Boeing's "World Air Cargo Forecast", annual world cargo growth of 6% to 7% is expected over the next 20 years - approximately double the forecasted 3% annual growth rate for the world economies. The International Air Transport Association expects global freight growth (based on metric tons) to average 6.7% per year between 2000 and 2004. Airbus's "Global Market Forecast" for the period 2000-2019 predicts that small freighter lift capacity will increase from 12,500 tons in 1999 to 26,300 tons in 2019.

Growth reflects continuing fundamental changes in global trade patterns such as supply chain innovations, including increasing use of outsourcing and JIT production and distribution, and e-business sales. Freight customers expect faster, more timely and more reliable service.

Passenger jet lower hold capability is limited by high passenger load factors that leave less space for revenue cargo, and many passenger aircraft already operate at their payload and range limits. In addition, air cargo traffic growth is forecast to exceed passenger growth by more than 1% annually. Consequently, by 2019, Boeing and others anticipate that jet freighters will provide as much as 44% of total air cargo capacity compared to 40% today.

Boeing forecasts that the jet freighter fleet will double over the next 20 years from 1,680 freighters in 1999 to 3,200 in 2019 - with the largest increases in medium (30-65 tons) and large size freighters (>65 tons).

Growth in the transborder and international markets out of Canada will exceed the more limited growth opportunities in the domestic market. This suggests that there might be a more competitive environment in the Canadian market.

Although air relations between countries have tended to focus on passenger services, all-cargo services are growing in importance. To shippers, air services offer a superior alternative to other modes of transport in terms of speed and the condition of goods upon arrival.

Many of Canada's bilateral agreements do not distinguish between passenger rights and all-cargo rights; that is, the rights applicable to passenger services could equally be used for all-cargo services. However, certain agreements contain specific all-cargo provisions separate from those for passenger services.

Many stakeholders, including communities and local airport authorities, have supported the negotiation of open all-cargo agreements in an attempt to encourage foreign carriers to operate such services to their cities. Given that there is no Canadian carrier presence in the international (non-transborder) all-cargo air services industry at this time, it is clear that fully open all-cargo agreements greatly exceed the current needs of Canada's international airline industry, which focuses on the carriage of cargo in the bellyhold of passenger aircraft. Although not the primary focus of international passenger carriers, the revenue from bellyhold cargo can make an important contribution to the viability of passenger services.⁹⁷

In August 1982, the federal government introduced measures designed to attract international cargo shipments to Mirabel airport as part of a broader effort to improve the use of Montreal area airports. Commonly known as the cargo transshipment program, this initiative allows foreign and Canadian carriers to be authorized by the Canadian Transportation Agency to carry international cargo transshipments via Mirabel coming from and destined to points outside Canada. In-transit cargo is stored in bond pending its transportation by air or other mode to its final destination. Carriers would not be authorized to carry Canadian originating or destined cargo unless licensed to do so under Canada's bilateral air agreements or arrangements or under the charter regulations. Carriers must meet all safety and security requirements imposed by Transport Canada and hold a Canadian Aviation Document.

The cargo transshipment program has since been expanded to Hamilton, Windsor and Gander airports (in 1987, 1993 and 2000 respectively) at their request. It is also understood that any transborder services may be operated by road feeder service using an air waybill, and that Canadian carriers are entitled to carry foreign-to-foreign cargo in bond separately or in combination with any existing authority to carry cargo to and from Canada.

The question that arises is what is the potential impact on the air cargo sector of the measures that could be used to expand foreign entry into the Canadian airline industry? Cabotage could reduce the operations of Canadian freight carriers because of the scope clause provisions in the FedEx, UPS and other US companies' contracts with their pilots. Scope clauses prevent Canadian carriers from operating to US hubs (cross border services) on a sub-contracting basis for companies such as FedEx and UPS. With scope clauses, US carriers must use their own aircraft and pilots on all jet category routes into their hubs and all routes where they have the right to fly. Thus, cabotage and scope clauses will limit sub-contracting opportunities for Canadian companies even though Canadian carriers are lower cost operators.

Modified sixth freedom rights could reduce traffic through airports such as Winnipeg and Hamilton because of a reduction in trans-Canada "milk runs" by Canadian carriers providing service for US and other foreign cargo/courier companies. For example, FedEx could serve the Vancouver to Montreal market through its Memphis hub.

Increased foreign ownership limits could expand access to capital for Canadian companies enabling them to increase their scale of operations, assuming that cabotage is not negotiated with the US or other countries.

There is nothing that the Canadian Government can do regarding scope clauses in US labour contracts. However, the Airline Pilots Association established a committee in November 2000 to study issues regarding scope clauses including:

· Scope, which defines the relationship between the union and the airline including policies related to the impact of airline mergers and job protection;

· Scope clauses that define what aircraft union members will fly and under what circumstances;

· Flow-through provisions, which set out how regional pilots may be promoted to mainline status (single seniority list).

A report is due in May 2001. Given the politically sensitive nature of these issues, there is no assurance that the pilots' union will recommend drastic changes to the existing scope clause provisions. However, if recommendations are made to scrap these provisions, even over time, the Canadian companies in the air cargo industry might benefit from a more open North American market because of their lower cost structures.

7.0 CONCLUSIONS

As noted in S. 2.1, the primary objective of this report is to assess the effects of alternative means for permitting foreign entry into the domestic market on the competitive landscape in both passenger and freight aviation services in Canada. The three options considered in this assessment in this report are:

· Increasing the foreign ownership limits up to 49% of the voting equity in Canadian licensed airlines;

· Granting foreign-based airlines modified sixth freedom rights, consecutive cabotage rights and/or stand-along cabotage rights;

· Allowing foreign-based airlines or foreign investors to start up and own up to 100% of the voting equity of an airline that is licensed to operate only in the Canadian market.

These policy options do address several of the entry barriers discussed above (S. 3.2). The possibility of entry into the domestic Canadian market by foreign airlines should increase the pool of management talent. As well, these airlines should be able to access capital at competitive rates, have access to distribution channels and be able to match or improve upon the competitive advantages of incumbent Canadian airlines. On the other hand, entry by foreign airlines will face the same infrastructure barriers as any Canadian entrant, and there may be few city-pair markets in Canada that offer any potential for profitable entry.

Relaxing the foreign ownership limits without changing the effective control provisions will address the capital barrier, but will do little to overcome the management barrier, infrastructure, market size and incumbent advantage barriers. Hence, these policy options will overcome several of the entry and survival barriers. But there is no assurance that any one or combination of these options will accelerate the rate of entry or expand the number and/or scale of operations of entrants.

7.1 Scope for New Entry

Foreign entry could occur in the following forms:

· Adding an extra Canadian leg to spokes currently terminating in a Canadian city (consecutive cabotage);

· Creating a domestic Canadian carrier (the Ansett or Virgin Blue strategy). A domestic Canadian carrier could be structured as a shuttle service in short, high density markets (the Impulse, US Airways Shuttle models); a hub-and-spoke network with a hub in Toronto or perhaps in Calgary, Winnipeg or Montreal; or as a point-to-point service (Westjet, Southwest models).

· Serving Canadian cities through existing US hubs (modified sixth freedom) such as Minneapolis (Northwest, Wings Alliance), Milwaukee (Midwest Express), Chicago (American, Oneworld Alliance), Detroit (Northwest), Cleveland (Continental, Wings Alliance) or Cincinnati (Delta, Skyteam Alliance).

With the exception of creating a domestic Canadian carrier, US airlines are more likely to consider entry into the Canadian market if they are to be granted modified sixth freedom rights or some form of cabotage rights. Non-US airlines do not operate US-based hubs that could be used with modified sixth freedom rights. As for utilizing consecutive cabotage rights to serve the domestic Canadian market, non-US airlines cannot offer the frequencies required to attract the business traveler and there is a greater likelihood of delays with overseas flights, further diminishing the attractiveness for the business traveler. But the Qantas experience in Australia under the country's Two Airline Policy indicates that non-US carriers could offer very cheap fares for the leisure traveler in Canada who is much less concerned with frequencies and punctuality.

Thus, although there appears to be scope for entry into the Canadian market by foreign airlines, the size and structure of the Canadian market may limit the potential for entry. There may be few city-pairs in Canada that would prove to be attractive to foreign airlines. There may be few markets that can support more than one or two competitors.

Low cost, low fare entrants into the US market and more recently into the European Union market have generally attacked the hub-and-spoke networks of the incumbents to open up "new markets". The geography and population distribution of the Canadian market greatly limit the potential for hub-and-spoke networks.⁹⁸ So too does the importance of Toronto Pearson Airport and the limited potential to create a hub at this airport.

A point-to-point network does not provide start-up airlines the same latitude to create "new markets" by over flying hubs. Rather, any entrant must go head-to-head in competition with the incumbents unless there are good secondary airports in major urban centres. In this respect the Canadian domestic market is much more similar to the Australian market than the US market. This suggests that there may be more limited scope for the creation of a domestic Canadian airline by foreign airlines or investors.

Adding an extra Canadian leg to spokes currently terminating in a Canadian city (consecutive cabotage), especially using regional jets, and serving two Canadian cities through a US hub appear to be the more likely avenues for expansion into the Canadian market, especially by US airlines. But flight frequencies are very important for time sensitive travelers - the full fare paying business passenger. Serving the Canadian market using modified sixth freedom rights may not provide a sufficient incentive for a US airline to offer a large enough number of daily frequencies between Canadian cities to attract the business traveler unless there are currently spokes from the US hubs to several Canadian cities. The inability to attract the "road warrior" reduces the attractiveness of offering the service between two Canadian cities via a US hub and further decreases the likelihood of attracting these customers. Of course, the economics of regional jets may enable US airlines to take advantage of modified sixth freedom rights and have their regional partners provide the necessary number of daily flights on select routes. But the more limited range of these jets limits their use on the trans-continental markets in Canada.

If US carriers were to start serving the Canadian market, other than by setting up a domestic Canadian subsidiary, the most likely markets to attract their attention are the eastern and western triangles and the trans-continental Toronto-Calgary and Toronto-Vancouver markets. The eastern triangle and trans-continental markets are the key domestic profit generators for Air Canada, and so Air Canada will not stand by and allow its market share to wither. The western triangle will be strongly defended by Westjet.

The experience of Westjet in Canada and Southwest in the US demonstrates that traffic can be stimulated, even in what appear to be thin markets, by low fares, reliable service and a reasonable number of daily frequencies. Therefore, there may be more opportunities beyond the obvious eastern and western triangles and the trans-continental routes to Toronto. But the number of entry points is still likely to be quite limited. The Australian experience to date reinforces this view.

7.2 Likelihood of New Entry

What is the likelihood that new entry may in fact occur if the Canadian market is opened to foreign airlines and investors? Who might enter and in what markets?

Let us start by considering the consecutive cabotage option. Foreign carriers, other than US carriers are likely to take advantage of this right if this will enable them to increase the daily utilization of their aircraft at relatively low cost or improve their competitive position in attracting business travelers on the trans-oceanic routes.⁹⁹ But there will be few city-pair markets that will be served and the service will cater to leisure travelers in Canada.

US carriers are unlikely to take advantage of this right because their focus is on building up their hubs and in the process they are minimizing the number of one-stop spokes to their respective hubs in order to reduce the spreading out effect of delays at their hubs throughout their entire networks. American and Continental are at the forefront, among the major US airlines, to keep each of their hub-and-spoke networks relatively independent of the others in their networks.

US carriers are more likely to consider the feasibility of adding a new non-stop spoke or additional frequencies on existing non-stop spokes to Canadian cities than to add another leg to an existing spoke to a Canadian city.

Southwest, AirTran and JetBlue may begin to fly to one or more Canadian cities. Under the Open Skies agreement with the US, these carriers can operate any transborder route they desire. The fact that they have not yet announced plans to fly to a Canadian destination suggests that they are more comfortable pursuing opportunities in their domestic market.

Southwest is more likely to expand in the US market than to begin to fly between Canadian cities. The company has made it clear that it only serves a very limited number of cities in the US at this time and that its market share is just 8%. So, Southwest's management strategic focus will likely be in the US. AirTran and JetBlue operate hub-and-spoke networks, with all spokes being non-stops from their respective hubs. It is unlikely that either will change its current network strategy and fly spokes from their hubs that connect two Canadian destinations.

The modified sixth freedom right is more likely to appeal to US carriers than the consecutive cabotage right. But as noted above, this right will have no attraction for non-US airlines. US airlines that already operate to more than one Canadian city from their hubs can quite easily offer a through fare connecting some Canadian cities. This possibility exists for US airlines with hubs near the Canadian border, otherwise, the inconvenience of longer flights may offset the benefits of lower fares for the time sensitive traveler, and on transcontinental flights.¹⁰⁰ Leisure travelers on the other hand, might be attracted by low fares and more time consuming connections through a US hub.

The option to start and own a domestic Canadian carrier is likely to be less attractive to foreign airlines than modified sixth freedom rights or consecutive cabotage. US airlines and possibly foreign carriers such as Virgin Atlantic, British Airways and/or Singapore Airlines might consider starting up a Canadian subsidiary. The Virgin Group has demonstrated its willingness to start up airlines in other countries - Virgin Express with its base in Brussels, and Virgin Blue. Singapore also has acquired controlling stakes in other airlines - Virgin Atlantic, Air New Zealand. British Airways did start up a low-cost subsidiary - go based at Stanstead - so this company might be attracted to the Canadian market. But Singapore is part of the Star Alliance and so has a strong link in Canada through Air Canada. British Airways however, no longer has a Oneworld partner in Canada. But we will return to British Airways shortly.

The track record of the Virgin Group to date does not provide much confidence that it will enter the Canadian market, or if it does, that it will be a long-term force in this market. Richard Branson has sold significant stakes in both Virgin Atlantic and Virgin Express and industry analysts in Australia expect him to do the same with Virgin Blue. Moreover, neither Virgin Atlantic nor Virgin Express¹⁰¹ is consistently profitable. Indeed, their financial performances have been marginal at best. Virgin Blue's entry into the Australian market was influenced by financial concessions by the Government of Queensland.

As for British Airways and any US carrier, the potential number of prospective entrants is quite limited. In light of the latest round of consolidation in the US, the existence of four distinct global alliances involving the major US airlines and the close links between the largest, independent regional airlines and the major airlines, the number of airlines that might potentially take advantage of greater access to the Canadian market is likely to be quite small. Neither Southwest nor any of the niche airlines in the US is likely to enter the domestic Canadian market because entry into the domestic Canadian market does not fit with their current route development strategies.

Of the four alliances, only the Star Alliance group has a presence in Canada. Of the other three, only the Oneworld alliance had a presence in the Canadian market prior to Air Canada's takeover of Canadian Airlines. American Airlines continues to have a code-sharing arrangement with Air Canada on former Canadian Airlines operated routes. Therefore, it would appear that the Oneworld group would have the strongest incentive to re-enter the Canadian market. But this group could re-enter through a marketing or code share agreement with Canada 3000. If the foreign ownership limits are increased to 49%, British Airways, American or the Oneworld group as a whole could take a significant equity stake in Canada 3000.¹⁰² Either of these options would involve a rather modest investment and thus would minimize the risks of gaining access to the Canadian market. And at this time, British Airways and American Airlines, the two lead players in their alliance, are faced with much more important issues.¹⁰³

The other two major alliances are less likely to be concerned about a limited presence in the Canadian market for two important reasons. The acquisition of USAirways by United and the proposed takeover of TWA by American may lead to additional consolidation in the industry and so the composition of both these two alliances may change significantly in the near future. Second, neither has had a strong presence in Canada in the past and the relatively small feed potential from Canada makes direct entry into the Canadian market a low priority, especially with a deteriorating economy, high fuel prices and a new round of restructuring of the airline industry worldwide.

Increasing the foreign ownership limits to 49% will not lead to entry by foreign airlines, but might result in further entry by Canadian carriers.

7.3 Impact of New Entry

If new entry by foreign airlines does occur, how might this affect the plans for further entry by Canadian companies and what might be the net effect on competition in Canada?

As discussed in S. 7.1 and 7.2, the scope for entry by foreign airlines is limited as is the likelihood that entry will occur. So the potential impacts might appear to be rather limited as well. But some entry will take place and given the size of the Canadian market and the fragility of the industry, particularly at this time of slower economic growth, even a limited degree of entry could have significant impacts on the Canadian airline industry. As pointed out in S. 6.0, modified sixth freedom rights or cabotage could decimate the Canadian cargo industry unless the scope clauses at the major cargo airlines in the US are changed to allow subcontracting to Canadian companies.

On the passenger side of the industry, the US airline industry has a graveyard filled with large numbers of unsuccessful entrants. There have been a number of failures of entrants in Canada and in Australia as well. During the past 15 months, two new airlines have started operating in Canada. Westjet, Royal and Canada 3000 have expanded their domestic operations. By comparison, in Australia only one domestic airline has taken advantage of recent structural changes and market opportunities to enter into the market, and the new Foreign Ownership Guidelines did lead to the entry of Virgin Blue. According to industry analysts, the entry of a foreign-owned carrier has effectively blocked entry by other domestic airlines in Australia. Only JetBlue has successfully started up during the past 15 months in the US, although all of the airlines have continued to expand their domestic networks.

Thus, we should not expect a free-for-all of entry if new policies are adopted by the federal government to encourage further entry into the Canadian market. The Canadian market, with the exception of a very small number of city-pairs, is very small. Indeed, the growth in the aggregate market shares of low-cost, low fare airlines in the US has been rather modest over the past 15 years, with much of the gain reflecting the continued success and growth of Southwest Airlines. Hence, whatever entry does take place will likely come at the expense of further expansion by the Canadian incumbents and likely will risk the future viability of one or more of these companies, unless the only change is a relaxation in the foreign ownership limits.

As pointed out earlier, every business plan allows for a given period to reach break even. However, if this point becomes sufficiently distant, irrespective of who is the backer, the willingness to fund the shortfall will cease. Access to the capital markets for Roots Air and even Canada 3000 might close rapidly if profitability is not attained. Furthermore, as the economy weakens, new entrants will be put to their toughest tests.

The airline industry is very cyclical due to a high correlation between demand for air travel and general economic conditions. Because the industry has high fixed costs in relation to revenues,¹⁰⁴ a small change in load factors or fare levels has a large impact on profits. Therefore, the longer or the sharper the slowdown in the economy, the poorer are the prospects for survival for new entrants regardless of whether or not foreign airlines choose to enter the Canadian market.

As for the argument that additional entry is needed to further reduce fares and spur cost efficiencies, the experience to date in Canada does support the view that competition is the best check on fares. However, most city-pairs have not seen new entry and are not likely to in the future regardless of the policy choices made by the federal government. Most city-pairs in Canada cannot support more than one airline. Indeed, there has been little entry into the routes served by the Air Canada Connectors, the regional airline subsidiary of Air Canada, for this very reason. Therefore, it is no longer a matter of entry to put downward pressure on fares, but the survival of the entrants to ensure that the competitive pressures will persist on even a limited number of routes.

A relaxation of the foreign ownership limits might do more to ensure the survival of domestic competition than any other policy changes.¹⁰⁵ This could increase the sources of capital available to Canadian airlines, and for the well-managed carriers, access to more sources of capital should also reduce the costs of capital.¹⁰⁶

As for the argument that a quasi monopoly may be inefficient and operate with too high a cost structure, the problem is not one of an absence of competition, but rather a lack of internal incentives and controls to limit waste. Unless one can demonstrate that in Canada, corporate governance is not taken seriously by public companies and their boards of directors and senior management's incentives are not aligned with those of shareholders, then an increase in competition is not required to spur efficiency.

In conclusion, in the absence of any policy changes, I would expect the following:

· Canada 3000 will continue to grow but will be marginally profitable;

· Westjet's financial performance may have peaked;

· Air Canada's financial performance is at risk because of high debt loads, a slow growth economy, substantial integration costs and the effects on increased domestic competition to date.

If policy changes lead to some foreign entry, then I would expect the following:

· There will be limited entry at best - there are a very small number of markets in Canada that provide entry opportunities - and the entry may end up displacing Canadian companies (in terms of the routes they operate and/or the number of frequencies they provide on existing routes).

· Even limited entry will weaken the financial performance of Canada 3000, Westjet and possibly Air Canada (depends on whether the changes are the result of unilateral actions or bilateral agreements and the potential of Pearson as a northern tier hub).

1 As the CEO of Canada 3000 recently noted, the Royal Airline merger will reduce capacity and competition on certain routes in Canada.

2 Also known as eighth freedom rights.

3 Ninth freedom rights.

4 With modified sixth freedom rights, American Airlines could operate Calgary-Chicago-Toronto for example, and sell Calgary-Toronto tickets to Canadian passengers.

5 Canada 3000 press release, January 29, 2001. Available through SEDAR website.

6 In 1999, each of the company's B757-200s, A320s and a330-200s were operated an average of 13.5, 12.2 and 13.8 hours per day. This level of utilization compares very favourably with the experiences of US carriers.

7 The company has been able to maintain load factors close to 85% for the past few years.

8 About half are served non-stop and the other half by one-stop flights. The city pairs include: Toronto-St. John's, Halifax, Moncton, Montreal, Winnipeg, Calgary, Edmonton, Vancouver; Vancouver-Calgary, Edmonton, Winnipeg, Ottawa, Montreal, Moncton, Halifax, St. John's; Calgary-Montreal, Moncton, Halifax, St. John's; Edmonton-Halifax, St. John's; Halifax-St. John's.

9 The acquisitions of Royal and Canjet will greatly expand Canada 3000's presence in the domestic market and thus enable the company to utilize its new aircraft in transborder and other international markets.

10 Victoria, Vancouver, Abbotsford, Prince George, Kelowna, Brandon, Calgary, Comox, Edmonton, Grande Prairie, Fort McMurray, Saskatoon, Regina, Winnipeg, Thunder Bay, Hamilton, Ottawa and Moncton.

11 PWA, Nordair, Quebecair and EPA.

12 Air Canada acquired 100% interest in its regional airline affiliates by the mid-1990s.

13 As early as 1980, American Airlines had pointed out the competitive importance and advantages of hub-and-spoke networks: "By linking flights together at connecting hubs, and coordinating arrival and departure times, American can offer frequent and convenient routings across a broad range of destinations. For example, a connecting complex that consists of 20 inbound and 20 outbound flights provides convenient through or connecting service between 400 city pairs. By adding one additional inbound and one additional outbound flight, the number of city pairs receiving such service is increased to 441. A hub-and-spoke system permits its operator to offer service frequency and realize load factors that cannot easily be matched by carriers that do not offer transfer facilities and related services. In effect, a connecting center allows its operator to offer a unique product, one beyond the reach of an airline that specializes in point-to-point non-stop service."

14 As an airline's percentage of the total available capacity on a particular city-pair increases, its share of the market increases more rapidly (and hence it achieves higher load factors than is competitors), ceteris paribus (fares and quality of service), until the airline becomes the dominant carrier on that route.

15 Air Transportation Association, also reported in "Aviation Week & Space Technology", January 22, 2001, p. 28.

16 Implicit in this assumption is that physical capital is fungible and available in infinitely small units.

17 That is, firms do not really compete since no firm has a competitive advantage or is assumed to have an incentive to create one.

18 The key assumptions are: no sunk costs - free entry and exit; entrants are able to quickly replicate the position and cost structure of the incumbents; and entrants are able to act more quickly than incumbents.

19 It is possible to show that low unit costs, low fares and low break-even load factors do not guarantee profitability in the airline industry. Low fares may not generate actual loads greater than or equal to break-even levels, if they are matched by the incumbents through the use of restricted discount fares and the incumbents offer a larger number of frequencies and greater capacity on the competing route(s).

20 Barriers an incumbent faces in trying to increase its market share at the expense of its existing competitors.

21 Economies of scale and/or scope, absolute cost advantages - proprietary learning curves, proprietary product and/or production technologies, quality of resources, switching costs.

22 Proprietary product differences, brand identity, distribution channels.

23 The reputation of management is the key variable influencing the decisions of financial institutions and individuals to invest in entry by new firms or established ones.

24 Among the defensive strategies that an incumbent can adopt are: market preemption or blocking, blocking access to distribution channels, predation, create switching costs, increase capital requirements, tie up suppliers, foreclose alternative technologies, raise competitors' costs, signal commitment to defend market share.

25 Slots are reservations for takeoffs or landings at specified times at an airport.

26 More commonly referred to as a "fighting brand".

27 Among the most recent fatalities are low fare carriers ProAir, which had its hub in Detroit, and Legend Airlines, which operated out of Love Field in Dallas. Vanguard Airlines, with its hub in Kansas City, is under competitive attack at its hub and may be the next airline to succumb.

28 Via modified sixth freedom rights, consecutive cabotage, stand alone cabotage or foreign-owned pure domestic airlines.

29 Profit to be defined in accounting terms rather than in economic terms.

30 Management is one of the most mobile factors of production.

31 For example, Melbourne-Sydney-Los Angeles or Melbourne-Perth-Singapore.

32 In 1981, the Independent Air Fares Committee was established to determine air fares, which were then applied by both airlines.

33 Every state other than New South Wales and Victoria had deregulated their markets.

34 Conversations with industry analysts at Potter Warburg and Credit Suisse First Boston and with management at Qantas.

35 International carriers were not given cabotage privileges as a result.

36 Both Air New Zealand and Ansett have undergone significant changes in their respective ownership structures during the past decade. In April 1989, the New Zealand Government privatized Air New Zealand. A consortium headed by Brierley Investments Limited initially bought the entire company. But after 30% of the shares were sold through an IPO to the New Zealand public and institutional investors, including 14 million shares to staff, Brierley Investments Limited retained a 35% shareholding, Qantas 20%, Japan Airlines 7.5% and American Airlines 7.5%. In February 1992, American Airlines sold its stake in Air New Zealand. In December 1994, Japan Airlines sold its 7.5% stake to Brierley. In October 1996, Air New Zealand acquired TNT's 50% equity interest in Ansett Holdings. In March 1997, Qantas sold its stake in Air New Zealand to institutional investors after it was not allowed to gain control of the company. In April 1999, Air New Zealand acquired News Corporation's 50% stake in Ansett Holdings and Singapore Airlines purchased 8.3% of Air New Zealand by purchasing Class B shares. Singapore also obtained approval from the New Zealand Government to acquire up to 25% of Air New Zealand's issued capital. Singapore Airlines reached the 25% limit in August 2000 when it acquired Brierley's B shares.

37 UBS Warburg research report on Air New Zealand.

38 At the present time, Virgin Blue is wholly owned by Richard Branson. It is not part of Virgin Atlantic or Virgin Express, but there is a code sharing agreement between Virgin Blue and Virgin Atlantic.

39 The company intends to raise an additional A$40 to $50 million in private equity later this year and to do an IPO in 2002.

40 Each has 117 seats in one class configuration.

41 The turboprop operations use the B1900D aircraft - a 19 seater.

42 As quoted in e-mail received from Impulse on March 1.

43 According to the Impulse e-mail, the airline would be working in a cooperative arrangement with the Tasmanian Government to launch and initially assist in marketing the new service.

44 Economists continue to debate whether the availability of capital is an entry barrier. One of school of thought argues that capital is readily available to fund any investment offering an appropriate risk-adjusted, competitive rate of return. However, another school of thought, and the one to which I belong, argues that the ability of management to successfully execute the strategy implicit in the investment is more critical than the investment opportunity itself. There is a general rule among venture capitalists that supports this latter view. A grade "A" management team with a grade "B" business model is more likely to be financed than a grade "B" management team with a grade "A" business model. The quality of the management team diminishes some of the risks inherent in any new business venture.

45 The Government of Queensland has publicly admitted to providing tax concessions worth up to A$10 million. However, industry analysts at several investment banks in Australia believe the value of the total package of financial assistance is much greater. So too do management at Impulse and Qantas believe that the financial assistance provided to Virgin is well in excess of A$10 million. It is interesting to note, that the Tasmanian Government also has offered financial assistance to lure Impulse to provide service between Hobart and Melbourne and connecting to the rest of Impulse's network.

46 In the opinion of industry analysts in Australia.

47 Each slot is for either a takeoff or a landing.

48 Industry analysts at Salomon Smith Barney, Potter Warburg and CSFB.

49 This strategy has been used by Delta (Delta Express), United (Shuttle by United), and US Airways (Metrojet) in the US and British Airways (Go) and KLM (buzz) in Europe.

50 Industry analysts at Potter Warburg and CSFB.

51 Neither entrant hedged against fuel prices prior to their entry into the domestic market, and neither has engaged in any significant hedging since entering into the market.

52 The breakeven load factor also depends upon yields. Lower yields increase the breakeven point. Lower prices may have a relatively larger effect on the breakeven load factor than on generating additional business (and hence the actual load factor) and so may result in larger losses.

53 Usually by reducing restricted fares only.

54 In a recent television interview (the transcript provided by e-mail on March 1), Gerry McGowan, Impulse's CEO, acknowledged that Qantas and Ansett will increase their respective capacity in the domestic market as they fight it out for market share. But he believes that the two airlines will be the major casualties.

55 In releasing its first half financial results (February 22, 2001), James Strong, the retiring CEO of Qantas alluded to the possibility that one of the new entrants will not be in existence by year-end.

56 Based on the opinions of industry analysts (Salomon, Warburg, CSFB) as expressed in interviews and research reports.

57 This view was widely held by analysts at Australian-based investment banks and senior management at the four domestic trunk route operators.

58 Qantas operates a core jet fleet of 107 aircraft, comprising B737s, 747s and 767s (including two B747-200s leased to Air Pacific). Qantas's subsidiary regional airlines operate a mixed fleet of 44 aircraft.

59 Press release, February 22.

60 Air New Zealand acquired 100% of Ansett Holdings and Gary Toomey, the former CFO and supposed heir apparent to James Strong, the CEO of Qantas, has taken over as CEO at Air New Zealand after he lost out in becoming the new CEO of Qantas.

61 Ansett's profits declined because of limited hedging against fuel and currencies (US$).

62 This also was the experience with Compass 1 & 2.

63 CSFB industry analyst, confirmed by management at Qantas and Ansett.

64 The results were released on February 20, 2001 and were reported on the company's website.

65 Management at Qantas, confirmed by industry analysts at Salomon, Warburg and CSFB.

66 Particularly B767s that can be used in peak periods and in some off-peak periods.

67 Frequencies, frequent flyer program, distribution channels, marketing to corporate accounts.

68 The close relationship with Singapore could be used to acquire a number of aircraft in a short period of time.

69 According to the strategic initiatives described on Air New Zealand's website and outlined in the press release accompanying the financial results for the first half of fiscal year 2001, the company already has started to address operating capacity deficiencies and the deterioration in market share on key routes in Australia.

70 Industry analysts have suggested that it would be in the best interests of Qantas and Ansett to have one of the entrants survive. This would greatly diminish the likelihood of any further entry and would lessen the likelihood that the federal government might change the competition law and other rules governing the airline industry to disadvantage the two major airlines.

71 In the case of Canjet, the IMP Group does not appear to have been willing to pour in money to keep the airline afloat since it showed little signs of generating an acceptable return on investment. Therefore, Canjet was shopped around.

72 The niche and regional airlines groups are not exhaustive. The largest companies in each group have been selected.

73 In most city pairs served by the regional airlines there is usually no more than one other carrier competing. The most prevalent form of competition is driving.

74 In addition, Horizon Air flies between Seattle and Victoria, Vancouver, Kelowna, Calgary and Edmonton.

75 Compare the number of passengers carried by Alaska Airlines, the smallest of the major carriers in the US, to the numbers carried by Westjet and Canada 3000.

76 America West initiated service between Phoenix and Toronto at the end of October 2000.

77 Compare to Westjet's 815 weekly departures.

78 Fort Lauderdale/Hollywood, Fort Myers, Tampa, and West Palm Beach.

79 Both of these companies were acquired in 1999 following American Airlines acquisition of Delta's regional partner in Boston and New York - Business Express.

80 Express Airlines I is a wholly owned subsidiary of Northwest and one of the airlines comprising Airlink.

81 US Airways owns three of these regional partners - Allegheny, Piedmont and PSA Airlines.

82 It is interesting to note that from July 1997 until February 1998, when it ceased flight operations, Western Pacific Airlines, a low-fare carrier, also provided hub service at Denver.

83 Dave Barger, President and COO - formerly VP of the Newark hub for Continental; John Owen, CFO - formerly VP, Operations/Planning for Southwest.

84 Al: Alaska; Awa: America West; Aa: American; Co: Continental; Dl: Delta; Nw: Northwest; Ual: United: Us: US Airways; Fr: Frontier; Mi: Midway: Me: Midwest Express; Aca: Atlantic Coast; Mes: Mesa.

85 Worldspan, Sabre, Galileo and Amadeus.

86 America West believes that each of its hubs is undersized relative to their potential, and so will focus on adding more frequencies and business markets at each of the hubs.

87 Yield management systems assure that there is an adequate inventory of seats available on all flights for business travelers.

88 More domestic and international destinations (through alliance partners) for free award travel; and elite level membership with unlimited first class upgrades, increased mileage bonuses and non-expiring miles.

89 For example, 54 new destinations out of Newark, including 13 to Europe, 11 to Latin America and one to Hong Kong; 55 new destinations out of Houston; and doubling the number of cities served from Cleveland.

90 Northwest has alliances with Nippon Cargo Airlines and with Continental, KLM and Alitalia.

91 For example, Love Field (Dallas), Ft. Lauderdale, Hobby (Houston), Islip (New York), Providence, Baltimore-Washington, Burbank, Midway (Chicago), Oakland, San Jose.

92 The company's market share and route profitability are greatest on routes where it offers the same or higher frequency and better timing of flights compared to its competitors. With the delivery of the CRJs and B737s, Midway has increased its scheduled flights from typically three flights per day per market to typically five flights per day per market.

93 Aviation Week & Space Technology, January 22, 2001, p. 30.

94 Changes in the scope clause provisions in the contracts between the major airlines and their pilots have opened up opportunities for the regional airline partners to introduce regional jets into their operations. But these jets are still skewed towards planes with 70 or fewer seats because of the remaining scope clause provisions.

95 John MacKenzie, All Canada Express, "Canadian Air Cargo Perspective" presented at Aviation 2000, Aviation Forecast Workshop, October 2000.

96 As quoted in Aviation Week & Space Technology, September 25, 2000.

97 For example, Qantas's daily Melbourne-Los Angeles nonstop is profitable because of the cargo carried on these flights, and oftentimes, the cargo/passenger configuration is changed to provide more cargo capacity.

98 Calgary serves as a hub for the Western Canada market and Toronto serves as a hub for the transborder market and trans-continental Canadian market.

99 For example, Cathay Pacific might be able to attract business travelers between Hong Kong and Toronto by extending its Hong Kong to Vancouver flight to Toronto, and the ability to carry Canadian passengers between Vancouver and Toronto may make it sufficiently attractive for the airline to operate a B747, B777 or A340 between Vancouver and Toronto.

100 The time factor makes flights between cities in Western Canada or between cities in Eastern Canada through a US hub unattractive for the business traveler.

101 Virgin Express has been experiencing declining load factors in 2000. When the company was acquired by its current owners in 1996, it entered into shared-service agreements with Sabena. Sabena purchased a certain number of seats on each flight (approximately 55% of available seats) between Brussels-London Heathrow, Rome and Barcelona. The shared service agreements terminate in 2003 and Sabena purchased approximately 58% of the total seats on all scheduled flights in 1999. Sabena's future as an independent airline is in serious doubt, and so there is no assurance that the service agreements will be renewed. Consequently, Virgin Express' future could also be very uncertain.

102 Canada 3000 is the most obvious candidate. Westjet, in following the Southwest model, is less likely to partner with another carrier. Roots Air is too small to provide sufficient feed traffic to the Oneworld alliance.

103 American is trying to acquire TWA, and if successful, will have to deal with the integration of TWA. British Airways is faced with increased competition in the European markets.

104 Once an airline has committed to a given schedule, a significant proportion of its capital, labour and material costs become fixed.

105 Other than stricter enforcement of the competition law.

106 Speaking to the Aviation Club of the U.K. in London on June 19, 2000, Continental Airlines CEO, Gordon Bethune, called for relaxation of restrictions on foreign ownership of U.S. airlines as the aviation industry faces a potential new round of consolidation. He claimed that artificial barriers to global investment are contrary to the economic interests of developed and underdeveloped economies alike. Consolidation in the airline industry is inevitable. Network-oriented industries such as transportation and telecommunications require enormous capital investment and worldwide connectivity, and these network businesses must constantly evolve to meet the changing needs of the global marketplace. He did add the proviso that relaxing foreign ownership restrictions should not be heard as a call for cabotage, which Continental is not advocating.