Times are tough and competition is intensifying for South East Asia’s (SEA) full cost carriers. Regional airlines must come up with new strategies in order to compete successfully and remain (or become) profitable. Some do not seem to have one, while others seem to not have the appropriate governance systems in place to handle the strategy.

For years, SEA airlines have been revered by their peers. Singapore Airlines has featured in Forbes'50 most admired brands.” Skytrax, a firm that conducts an annual worldwide survey to determine the best airlines, has featured three SEA airlines in its 2011 top 10 ranking. SEA’s high ranking in 2011 is not an outlier, but a norm. SEA airlines are also the most profitable. Cathay Airlines and Singapore Airlines have topped the profitability ranking this year and have done so before as well.

But this success in the past should not lead to complacency in the future. Recent developments and forecasts show a troubled road ahead. Higher fuel prices will impact firms’ costs, while political unrest, natural disasters and increase in competition from low cost alternatives will hit carriers’ revenues. Although somewhat expected, IATA statement a few weeks back that airlines' profits are likely to sink by 54% in 2011, surprised many by its glumness. This leaves SEA’s full-price airlines with few alternatives. They can attempt to increase their sources of revenue and just like European and American peers start charging extra for carry-on luggage. They can pursue consolidation to attempt to reduce costs, a strategy also followed in Europe and America by United Airlines and Continental, KLM and Air France, or Iberia and British Airways which in the past has led to overpayment and significant wealth destruction for shareholders. Alternatively they can pursue improvements in efficiency and productivity. The first strategy will likely only postpone the problems and not solve them, although some may think that postponing may be enough as fuel prices will likely decrease after the impact of Japan’s earthquake and tsunami and the frenzy of the Arab Spring subsides (unless Spring becomes Summer, and Summer becomes Fall). The second strategy may be a “hard sell” as most SEA full cost airlines are at least partially state-owned. Governments are likely to consider them strategic assets and any attempt at consolidation will face political resistance. The third strategy is the better bet, although the most painful of the three as improvements in innovation and productivity do not happen over-night. These improvements usually require a mindset and cultural changes at the firm.

But the right strategy will not solve all. Firms must ensure that they have a governance system robust enough to support the strategy. This is where firms are usually found wanting. The way a firm measures and rewards the performance of its employees and business units; the process through which firms analyse acquisitions, capital raising and capital investments; and the way a firm conducts its annual planning exercise constitute a significant part of its corporate governance system. A review of these processes at regional airlines sheds a light on how dysfunctional governance systems can be.

A study of the performance measurement systems of regional carriers shows that most look at several metrics to assess performance but none of these metrics is comprehensive. The metrics used (EBITDA, Net Income, ROE to name a few) have low correlations with share price movement as shown in our table below. Hence, while employees pursue improvements in these metrics, shareholders may be faced will lower returns. This is what Michael Jensen, Professor Emeritus at Harvard University terms the agency cost.

Furthermore, we find that many companies (not only in the airline industry), may look at a myriad of metrics to measure performance but do not use these metrics to determine the variable compensation of their employees. They will usually rely on other metrics. Some firms will provide share-options to employees, but measure their performance based on EBITDA. Since EBITDA has a low correlation with share price movement, these employees will face a dilemma, either perform to expectations and improve EBITDA or forget about EBITDA and do the best they can to concentrate on the metrics that are better correlated with share price movement. Sadly, employees may not know which metrics lead to improvements in share price and are left pushing EBITDA and seeing their bonuses fall. Frequently, variable compensation is not even based on any specific metric but is left to the CEO’s discretion. Bonuses then tend to depend more on an employee’s golf game than on his professional performance.

When it comes to capital stewardship, we find from experience that firms will design overly bureaucratic and complex capital budgeting processes that starve their divisions from capital as they do not trust that their divisions will employ those funds efficiently. Nevertheless, divisions have learned to play the game and are able to secure funding for their projects by goal-seeking the NPV or IRR of a project.

Acquisitions and fund raising usually involves a valuation using some type of earnings multiples. This approach usually works well for investment bankers as it reduces their workload, but it usually leads to mispricing and overpayment on acquisitions. Notice how the buyer’s share price almost always declines when an acquisition is announced or look at Garuda Indonesia’s disastrous IPO earlier this year.

Another process that is usually chaotic is a firm’s annual planning. We find this is usually a high stake game of negotiation. CEOs or the Board usually determine the group’s target and then assign targets to the different divisions. It is at this point where the divisions are supposed to present their own targets,and guess what? Theirs are usually lower than the CEO’s target. Surprised? Why? If employees are rewarded on achieving a certain target it is in their interest to try to make that target as achievable as possible. Failure to achieve that target can lead to a lower bonus or even dismissal, there is just too much at stake.

A governance system that is transparent, objective and simple to understand must be implemented. Employees should understand that by achieving “X” they are entitled to “Y.” They must feel that they are assessed on things they can influence and understand. On the other hand shareholders should be comfortable with the company making investment decisions and for this employees must be held accountable for all costs, including capital. This will make capital more available as employees will treat it as if it was their own.

To conclude, regional carriers should concentrate on improving their internal governance systems to ensure that whatever strategy they implement, can yield the expected results. The changes needed at these firms are significant, will take time to implement, and will be painful. But if changes are made now, carriers will ensure that they will keep flying profitably for many years to come.

Article by: Martin Schwarz

Research by: Janet Uy and Melisa Soentoro