S w 9B10N037 Professors David Wood and Craig Dunbar wrote this case solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. Richard Ivey School of Business Foundation prohibits any form of reproduction, storage or transmission without its written permission. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Richard Ivey School of Business Foundation, The University of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661-3208; fax (519) 661-3882; e-mail cases@ivey.uwo.ca. Copyright 2010, Richard Ivey School of Business Foundation Version: 2010-12-14 In early 2011, Calin Rovinescu, the chief executive officer (CEO) for Air Canada, was reviewing the company's risk management program. Risk management was an important issue for Air Canada, and he knew that any changes to the policy would need to be reviewed by the board. Given that four of the 10 board members were relatively new appointments, Rovinescu's presentation would need to be comprehensive. The next regularly scheduled board meeting was just a short time away, so Rovinescu had to move quickly. AIRLINE INDUSTRY The airline industry had seen its share of challenges over the past few decades. In 2001, the attacks of September 11 on the World Trade Center and the Pentagon had put the industry into a two-year downturn. Fortunately, passenger traffic had begun to increase in 2003, but so too did the cost of operating an airline. An increase in both air traffic and the number of new airport terminals drove up the landing fees, but the largest cost increase was in the price of fuel. Since the beginning of 2000, the price of the light sweet crude oil (also known as West Texas Intermediate, or WTI) used to make jet fuel had risen from roughly $27 a barrel to a high in June 2008 of more than $133 a barrel. Health-related concerns had also interrupted highmargin international travel, including SARS (severe acute respiratory syndrome) in 2003 and the H1N1 influenza in 2009. Finally, the financial crisis in 2008 and 2009 had helped to lower the price of fuel, but passenger air travel had also declined by 5.4 per cent in Canada, and financing had become more difficult for the airline industry.2 The International Air Transport Association (IATA) estimated that over the past 10 years its 240 member airlines had lost US$49 billion.3 In the United States and around the world, consolidation became the primary mechanism used by the airline industry to address these challenges. By 2010, the top 10 per cent of all U.S. airlines accounted for 80 per cent of the $130 billion industry. Global expansion also became important for survival as these 1 This case has been written on the basis of published sources only. Consequently, the interpretation and perspectives presented in this case are not necessarily those of Air Canada or any of its employees. 2 Air Traffic at Canadian Airports, Minister of Industry, June 2010 Available at http://www.statcan.gc.ca/pub/51-203-x/51-203x2009000-eng.html, accessed December 2, 2010. 3 \"Canada's Airlines: Risky Business,\" CBC News, June 17, 2008, Toronto, Ontario. Authorized for use only in educational programs at Laurentian University until Dec 06, 2019. Use outside these parameters is a copyright violation. AIR CANADA - RISK MANAGEMENT1 Page 2 9B10N037 Although consolidation of the large legacy carriers became a predominant strategy for survival, many of the smaller low-cost carriers continued to grow organically. In the United States, Southwest Airlines now ranked second among domestic carriers and JetBlue Airways ranked eighth. In Canada, WestJet had solidly entrenched itself as the number two carrier in Canada and had also expanded internationally into the United States, Mexico and the Caribbean. The low-cost carriers had built their business model on superior operations, servicing from lower cost airports, flying point-to-point and using a single type of aircraft. Recently this model had evolved because the expansion of these carriers had required them to add a second or third aircraft type. However, not all low-cost carriers had been a success. In Canada, Canada 3000 ceased operations in 2001, Jetsgo folded in 2005 and CanJet stopped servicing scheduled flights in 2006, as did Harmony Airways in 2007. Fortunately, industry performance improved in 2010. At the end of the third quarter, the U.S. airline industry had produced a modest 0.2 per cent net profit after taxes. In addition, prices had increased four per cent after an eight per cent decline in 2009. Airlines also experienced an increase in revenue per seat, as customers became more comfortable with paying for services. Since 2008, the trend to charge for additional bags, blankets, headphones, drinks and food were all beginning to receive broad customer acceptance. Finally, the forecast remained optimistic for the foreseeable future (see Table 1). Table 1: Projected Year-to-Year Change in U.S. Consumer Spending on Airline Travel5 Year 2010 2011 2012 2013 2014 2015 % Change 11% 7% 7% 7% 6% 6% Although the forecast provided a rare opportunity for optimism in the airline industry, insiders recognized that the state of the global economy remained a concern. The United States had recently introduced QE2, a second round of quantitative easing, to prevent a sluggish economy from stagnating. And in Europe, the European Union had recently agreed to finance Ireland and the Irish banking system to prevent further financial collapse. In the past decade, airline executives had realized the one thing they could rely on was uncertainty. 4 5 \"Industry Profile: Airlines,\" First Research, Quarterly Update September 13, 2010. Ibid. Authorized for use only in educational programs at Laurentian University until Dec 06, 2019. Use outside these parameters is a copyright violation. international flights were typically more profitable and accounted for 45 per cent of all air passenger revenue in the United States. Even those airlines that did not consolidate had joined code-sharing alliances to drive up their load factors. Passenger loading remained the primary performance metric for airlines because of the high fixed cost nature of their business. The leasing costs for equipment were five to 10 per cent of total expenses, and labor (typically unionized) accounted for another 30 per cent. Landing fees were only two to five per cent of total expenses, but fuel was more volatile and ranged from 20 to 30 per cent of all costs.4 Page 3 9B10N037 AIR CANADA On September 30, 2004, Air Canada emerged from bankruptcy protection with the support of an $850 million financing package from Deutsche Bank. Following the failure of two earlier proposals from Cerberus Capital Management and Victor Li, Air Canada and the Canadian Auto Workers (CAW, the union representing Air Canada employees), agreed to the Deutsche Bank condition of a further $200 million reduction in annual costs over and above the $1.1 billion in cuts that the unions had agreed to in 2003.7 In the years since the restructuring, Air Canada remained focused on cutting costs, improving revenue and restoring the public trust. Between 2004 and 2007, Air Canada generated an operating income, but due to the deteriorating economy, lost money in both 2008 and 2009. Air Canada's strategy for the past two years was primarily focused on cost cutting, reducing capacity and managing the risk from pending labor contracts and the pension solvency deficit. As a result of an improving economy and growing industry, the focus for Air Canada had changed. Rovinescu believed that Air Canada's future required the company to focus on four key initiatives8: 1. 2. 3. 4. Expanding international operations Generating incremental revenue and significant costs savings Refocusing on customer service and promoting the premium cabin Fostering a culture of change Air Canada's most recent financial results from the third quarter of 2010 were encouraging. Revenue was up, and the previous year's operating loss had turned into income (see Exhibits 1 and 2). The primary reason for the improvement was an increase in demand. In particular, passenger spending had increased on the more profitable international routes, led by the Pacific region, which was up 17 per cent.9 In addition, demand for the high-margin premium cabins accounted for roughly half the $256 million increase in sales. However, many analysts still considered the stock to be a \"speculative\" buy. THE BOARD Air Canada's board members were seasoned leaders in their own fields. The board was comprised of accountants, lawyers, physicians, politicians and former chief executive officers from the airline industry and others from outside the industry (see Exhibit 3). The board was a relatively new group. The most senior members had been with the board for only four years, and four of the 10 members had served on Air 6 \"Indepth: Air CanadaAir Canada Timeline,\" CBC News, June 2005. Available at http://www.cbc.caews/background/aircanada/timeline.html, accessed December 2, 2010. 7 \"Air Canada faces deadline with Deutsche Bank deal\