ALAN GLUCK, Sr. Manager Aviation, ICF
Concessionaires need to understand the new business reality when they ask for relief
COVID-19 has sent shockwaves throughout the world. From layoffs to business closings, social distancing to shopping only on days that correspond to the first letter of your last name, we have all seen and felt the impact. Having been hit particularly hard, airports are searching for answers to problems on a scale that simply wasn’t imaginable six months ago.
Updates to the FAA guidance
The FAA has issued additional guidance on airport concession fees, some of which reverses earlier policies. First, and potentially most important, the FAA’s position on rent abatements has gone from “NO” to: “A decision to abate rent (including ‘minimum annual guarantees’ and encompassing fees) is a local decision. Rent abatement should be tied to the changed circumstances caused by the public health emergency and done in accordance with Grant Assurances 22 and 24, as well as related statutes. Where abatement results in shifting costs between various classes of airport tenants and users, the airport sponsor is encouraged to consult with all affected parties…”
Besides giving each airport blanket permission to decide its own strategy, the emphasis on shifting costs between various classes of airport tenants is crucial. In airports with residual airline agreements, the airlines will be required to make up the difference between revenue to the airport and required revenue to pay for airport development and other expenses. The key will be ensuring that airline charges remain fair and reasonable. Concessionaires need to understand this new business reality when they ask for relief. If relief drives airline costs to a significantly higher level, thereby reducing airport cost-competitiveness, airlines may choose not to fly to the airport or to operate fewer services. If flights do not return to their pre-pandemic levels, then the airport will not be able to recover former passenger levels. That will, in turn, harm the concession program.
What will airports be in the future?
No one is sure how long recovery will take. Nor do we know whether travel habits will change permanently because of new practices learned during lockdowns. At least for the immediate future, there will be reduced demand for concession services. Most experts agree that there will be no quick snapback of passengers, so airports face the issue of having too many concessions locations or even too many operators. It may be necessary for an airport to close concession locations as they may close portions of the airport to reduce their operating costs.
The April 4th FAA guidance permits this: “In coordination with airport sponsors, airlines, the Transportation Security Administration (TSA), and other entities, closing gates or sections of terminals is likely to be acceptable if the closure is executed in response to reduced passenger volumes and operations, is not discriminatory, and does not provide an unfair competitive advantage to one operator. For example, TSA has reduced lanes or consolidated passenger screening checkpoint operations in numerous airports in response to the reduction in originating passenger volume.”
If an airport operator closes a concourse or a terminal, it would need to eliminate some concession spaces from its contracts, which may render some deals no longer viable. The competitive landscape may be—by necessity—altered. When passenger traffic does come back, airports should rethink how their concession contracts work. Airports should carefully consider how they structure deals and their business models to ensure more flexibility to respond to potential future shocks.
The fallacy of Minimum Annual Guarantee (MAG)
In times of continued and prolonged growth, airports have learned to depend upon MAGs. In North America, airports tend to look at MAGs as the least amount of acceptable rent. In other parts of the world, MAGs are the airport’s exact expected rental payments. North American airports generally believe that if a vendor is paying a MAG, there may be a business problem. Elsewhere, airports do not expect vendors to exceed their MAGs. In either case, history has shown that MAGs are not supportable in the event of severe downturns.
The current decline dwarfs those of the recent past, as enplanement levels have dropped by upwards of 90%. However, MAGs in concession contracts still expect continued growth. Many airport agreements allow for a suspension of MAGs in the event of a severe enplanement decrease. If the metric for rent resumption is comparing the current period to the same period in the previous year, by the time the world reaches year two of recovery—even if the improvement is only slight and slow—the contract may reinstate the original MAG.
Charting a new course
It’s clear that fixed MAGs are unable to provide the flexibility necessary to deal with severe occurrences. A different methodology is required to ensure that vendors are allowed to earn a fair return on their investments, are able and willing to reinvest to improve and grow, and still provide a reasonable return to the airports. Where do we go from here? Let’s consider six potential options.
Option 1: MAG based on enplanements
The single factor most tied to concession success is the footfall past the concession locations. Hence, a fairer methodology for establishing a MAG is to base it on an absolute value per exposed passenger. There are means of counting passengers who pass a concession location, but few airports have installed such technology. A per enplanement MAG would be a strain on most airports’ accounting departments, especially if the footfall varies by location. A by-location per passenger MAG may be too complicated for widespread implementation at this point.
Calculating MAG based on traffic in a larger area (e.g., the concourse or terminal) is one possible answer. While this methodology is feasible, it does not get to the actual number of passengers who see a concession location. What this option does do is change the distribution of risk. In a standard MAG model, the concessionaire bears a great deal of uncertainty with little risk falling to the airport. With a MAG based on enplanements, the airport accepts the risk of failing to deliver enough enplanements. However, this still may not be the most effective solution.
Option 2: MAG on a per square foot basis
Non-airport retail leases typically charge rent on a per square foot (PSF) basis. Most airports already calculate a PSF rent amount in their airline rates and charges (e.g., office space with passenger access) that applies to concession-type spaces.
There are a few limitations, however, that make this a less than optimal solution. Primarily, in residual agreements, the rates vary based on airport revenue. As a result, if concessionaires produce lower sales because there is no traffic, it will result in space rental rates increasing.
Depending on the level of the sales decrease, the resulting increase in space rental rates may lead to concessions being no longer economically viable.
Because this rate base is not related to passenger numbers, it is equally as inflexible as a MAG set by any other means in the event of significant changes in enplanements. As a result, airports may wish to consider going a step further.
Option 3: Elimination of MAGs
As is becoming evident, basing financial remuneration on an aspirational or required number—or even recent experience—can fail. A MAG, as currently developed, is unsustainable in anything but relatively normal times. If the basis for a MAG is what the airport thought it should be earning, the amount may never be supportable even if a concessionaire signed the contract. This leads to another possibility: to eliminate MAGs and tie airport payments to sales only.
This essentially flips the rent risk from being entirely on the vendors (in a MAG-based model) to being entirely on the airport. While the vendor still has some risk to pay for its investment and employee wages, rent is solely dependent on sales. Given the focus on bottom line profits, the investment in variable costs—such as employees, training, maintenance, and product development—required to earn additional sales may no longer make economic sense.
There are numerous ways to frame a contract without a MAG. Most simply, the airport and vendor could agree to a fixed percentage rent. Alternatively, different percentages could be charged for varying levels of sales or by assigning either fixed or variable rates to different product categories (e.g., one percentage for food and non-alcoholic beverage and a separate percentage for alcoholic drinks only). Regardless, this shifting of risk may not be acceptable to airports.
These three options do not change the underlying airport-concessionaire relationship. Yet one of the most severe barriers to entry, particularly for small businesses, has always been limited access to capital. With the new economic and industry realities, capital access may be an even greater hurdle. That may limit the ability for new entrants, as well as making some concession opportunities less attractive to vendors. Given that we are considering a new paradigm, airports and concessionaires may wish to consider three other business structure options.
Option 4: Airport-concessionaire joint ventures
Airports outside of North America are already experiencing the benefit of joint ventures between the airport operator and concession operators. While the model has primarily been used for duty free concessions, it has worked equally well for other types of concessions.
In this model, the airport takes on two roles: landlord and partner in the operation. The joint venture lease must be similar to those given to other concessionaires, and enforcement of the airport’s rules and performance requirements must be uniform. While the airport might invest capital in the joint venture, it must be involved in a management committee overseeing the business. How involved the airport gets in the day-to-day operation is the option of the airport and their partner(s). One of the keys, however, to the success of this model is the realization that each partner brings particular strengths, skills, and abilities. When one partner tries to do too much, it will lessen the benefits of the joint venture. As such, most airports should stay out of active management of the concession location, leaving that to the expert partner.
Another advantage of this model is that it may provide a means to improve the levels of involvement of smaller and local businesses. The joint venture model allows the airport to supply capital, likely at a lower cost than its business partners. The airport operator also brings knowledge of how to do business in an airport environment while allowing the concessionaire to concentrate on what they do best: operate a highly successful restaurant or shop.
Option 5: The Trinity (or Trinity Plus) model
The Trinity model can be considered an extension of the joint venture model. First championed by Martin Moodie—one of the stalwarts of the concession industry—this model has airports, retailers, and suppliers cooperate in developing concession operations. Considering all the current changes in our business, this model may be a solution to sharing risk and encouraging a strong representation of critical brands in airports. The Trinity model is particularly applicable to duty free concessions, where it is practical to divide a store into departments wherein vendors (e.g., Channel, Rolex, Hèrmes) are given the ability to design and operate their mini outlets.
Airlines have a significant stake in the quality of the concession program because of its impact on the passenger experience. Airlines value an attractive commercial program because it makes a better background for the expression of their brand. The passenger experience results from a combination of the actions or inactions of airport, concessionaire, and airline. This suggests that the best way to ensure an outstanding customer experience would be for this Trinity (or Trinity Plus, including the supplier) to work together. Each contributes its expertise, capital, and support to result in a uniform, consistent, and superior customer experience throughout the passenger’s journey.
While this model is new, a unified strategy could bring about a unique airport concession experience to the benefit of all participants. This strategy is particularly applicable for a hub airport where the hub airline’s brand expression is likely already an important part of the airport’s perceived brand.
Option 6: The airport as concession operator
If an airport can become a partner in the operation of a concession, it might also consider being a concession operator on its own. This option would give the airport operator the ultimate control over its concession program as it takes on full responsibility for all business aspects. Manchester Airport Group in the U.K. had started to operate a restaurant in their home airport before the pandemic, so there is precedent for this strategy.
The airport operator is always present and has a wealth of knowledge about the airport. However, it is unlikely that most airport operators have staff with specific expertise in concession operations and management. Without this expertise, the concession will almost certainly fail to operate at an optimum level. Airports would also have to establish supply lines for products that they have not procured in the past. These supplier relationships are unlikely to have the same economies of scale as those of national concessionaires, which means the costs of operation may be higher.
Airports would also have to hire and manage many additional hourly employees. The airport human resources function is likely not ready to handle that, as the annual turnover of concession employees often approaches 150%. Most airports are not prepared to be on a constant hiring cycle for entry-level hourly employees. Airports would have to offer benefit packages to these employees in line with those provided to other employees of the airport. These benefit packages may make the cost of employment significantly higher than the all-in employment costs for most concession operators.
The airport environment is complex and has become even more challenging due to COVID-19. Airports should consider alternative methodologies for managing and operating their concession programs for concessions to remain viable business options. While it may never be “business as usual” again, the airport and its business partners need to adjust to a new normal. There will still be passengers, and the concession industry needs to be ready to serve them.
For more insights from Alan Gluck and ICF, please go to https://www.icf.com/insights/transportation