The Crane's Pain

Lufthansa, rescued by its government, tries to reset

At least it’s not alone.

Having to take $10b in aid from its government was no easy pill to swallow, coming at a steep cost. But Lufthansa, suddenly 20% owned by the German state, has plenty of company. Its three main rivals, noted CEO Carsten Spohr, have at least as much government ownership, which was the case even before the crisis. He’s referring to Air France/KLM (28% owned by the French and Dutch governments), IAG (25% owned by state-controlled Qatar Airways), and Turkish Airlines (51% owned by its government in Ankara). All around the world, meanwhile, airlines are receiving huge doses of emergency government aid. If misery loves company, then that Lufthansa has.

What it doesn’t have is a particularly promising profile for the new industry conditions created by the Covid crisis. Lufthansa — nicknamed “the Crane” for the bird on its logo — has long relied more on premium intercontinental demand than its rivals, and more on a cargo market that’s yielding unique opportunities for the moment but simultaneously shrinking and challenged longterm by diminishing world trade. Lufthansa’s giant maintenance arm, along with its catering unit, will have fewer clients and less revenue in a sharply contracting airline industry. Lufthansa’s passenger business too, entered 2020 already burdened with deep structural challenges, not least the incessant losses at Eurowings, a low-cost unit with nearly $5b in revenue last year (that’s similar to what Scandinavia’s SAS produced). Austrian’s problems were no less severe. Ditto for Brussels Airlines.

The group’s sickly 5% operating margin last year reflected these weaknesses. Lufthansa’s core mainline operation did somewhat better. Swiss, the all-star of the group, did better still. But it was a tough year in general, clouded by labor tensions, Brexit fears, NEO delays, cargo weakness, and vicious shorthaul LCC battles in Germany and Austria. By year end, longhaul routes to North America, Latin America, and Asia were all experiencing significant yield declines, in part because Germany’s largest exporters (think companies like Volkswagen, Daimler, and Siemens) were cutting their travel budgets as overseas markets like China weakened.

Speaking of China, Lufthansa and its affiliates were operating 11 routes to five mainland cities (from Frankfurt, Munich, Zurich, and Vienna) when the Covid virus started spreading from Wuhan in January. Among Europe’s airlines, only Air France/KLM and Finnair had more China exposure. Soon, Lufthansa’s entire Asian franchise was in freefall. Next, the virus spread to Italy, and wealthy northern Italy more specifically, a critical market for Lufthansa — it even owns a small Italian carrier there called Air Dolomiti. To its great relief, the group refrained from satisfying a pre-crisis temptation to invest in Alitalia.  Whew. 

All of this made for a nightmarish first quarter. As it belatedly reported last week, Lufthansa suffered a monstrously bad negative 19% operating margin for the period, substantially worse than even Air France/KLM’s negative 16%. A year ago, the group’s Q1 operating margin was negative 4%, which was bad enough. It was forced to slash passenger ASK capacity by almost a fifth y/y, with revenues falling nearly as much. But costs were much slower to disappear, dropping just 6%. Fuel hedging proved toxic, costing the airline $148m in the quarter, while causing massive negative accounting adjustments that ballooned the company’s net losses. Its net result would have been worse still if not for heavy income tax relief.

The big relief though, was the $10b in government aid that Lufthansa’s board approved last week. Without that help, cash would have emptied quickly — it’s currently burning through nearly $900m a month, which includes cash outflows from those toxic hedges. Raising capital from private markets was possible, management said, but extremely expensive. So to the state it was forced to turn. Of the $10b, Berlin will pay some $330m in cash to the airline for the 20% stake. The airline gets another $3b-plus in the form of guarantees for a three-year loan. A more substantial $6b lifeline comes as additional taxpayer equity that Lufthansa needs to repay, with interest. It gives the government certain rights such as options to take an additional 5% stake in the event of a takeover attempt, or if the company fails to meet its repayment obligations.

These obligations, make no mistake, are massive, exceeding $10b including interest and coupon payments, with incentives to repay sooner rather than later — interest rates will rise over time. Berlin won’t get to influence the management of Lufthansa, pledging not to exercise the voting rights of its two new board members except in a takeover scenario. It also intends to sell its shareholdings in full by the end of 2023. The arrangement does contain some restrictions on Lufthansa’s right to pay dividends, pay bonuses, and buy other companies. There are some environmental conditions too, but not as strict as what Paris imposed on Air France. The E.U., meanwhile, is requiring Lufthansa to surrender some Frankfurt and Munich airport slots to new entrants, or incumbents if no new entrants are interested.

The group also secured $1.6b in loan guarantees from Switzerland’s government. It’s close to getting aid from Austria too, and perhaps Belgium.  Europe’s competition authorities still need to sign off on the deal with Berlin. So do Lufthansa’s shareholders later this month. But assuming the likely scenario that everything goes through, Lufthansa next has the arduous task of rebuilding its already-shaky business while burdened with huge new financial obligations. And it must do so in the middle of a health pandemic, depression-like levels of global unemployment, and a freeze in corporate travel that could take years to thaw.

This isn’t of course unique to Lufthansa. But many of its key rivals, including Turkish and IAG, have a lower cost base, less debt to repay, and arguably less competitive pressure. Most key non-European rivals, furthermore, don’t have toxic fuel hedge contracts draining company coffers. Within Europe, as the quick recovery in shorthaul, low-cost, leisure markets plays to the strengths of LCCs like Ryanair, Wizz Air, and easyJet, it’s the opposite case for Lufthansa, whose shorthaul leisure network is the weakest part of its business. 

All of this makes its current restructuring efforts extra critical. Lufthansa already says it might have to sell assets to service its new debt obligations. Fortunately, it owns most of its planes. It still plans to sell its international catering activities. Before the crisis it was considering a partial sale of its maintenance unit. Might it look to sell one of its airline units? Now is no time to sell aviation assets though, and it’s unclear if and when markets will recover. 

Like other airlines reacting to the crisis, Lufthansa has already cut its aircraft commitments, implemented government-assisted part-time work programs for 87k workers, and deferred some non-essential maintenance. But uncomfortably, Lufthansa’s single biggest path to longterm survivability, let alone prosperity, is reworking labor contracts. That, to put it mildly, won’t be easy. It’s telling unions that layoffs might yet be avoided, but only with meaningful pay, benefit, and work rule concessions. The group remembers all too well what unfolded after the global financial crisis, when IAG for one addressed labor cost inefficiencies early and thoroughly, helping it produce a decade of superior margins versus its slower-moving rivals Air France and yes, Lufthansa. 

Cargo will be a lone bright spot this year, with higher yields expected to generate a y/y increase in profit margins. But things will be tough for maintenance and catering. And recovery in the passenger airline business will take “multiple years.” Lufthansa still intends to pursue its pre-crisis restructuring of Eurowings, including an exit from longhaul flying. But it will be a lot smaller than the original turnaround plan prescribed, having entered the crisis with 191 planes (including the Brussels fleet, plus planes it acquired from Air Berlin). Eurowings will now fly fewer than 100 planes. The group, meanwhile, still seems keen on creating a new brand for low-cost longhaul flying from Germany, including Frankfurt and Munich, modeled on its Edelweiss operation in Switzerland.

Groupwide, Lufthansa expects to downsize its fleet by a massive 300 planes next year. In 2022, it expects to have some 200 fewer planes. And even by 2023 and beyond, after traffic has fully recovered, it will be some 100 planes smaller, though with more seats per aircraft. The point is, it wants to do more with less. Already, it’s decided to permanently retire six A380s, five B747-400s, and 11 A320s. Its 17 A340-600s will be temporarily grounded for at least another 12 months. At Austrian, three B767s and 18 Q400 turboprops have already been retired. Brussels, whose specialty is sub-Saharan Africa, will no longer be part of Eurowings. Management hasn’t yet said what it plans for the 20 giant B777-9s due to start arriving next year. In total, Lufthansa began the year with 198 planes on order, including 30 A350s, 20 B787s, and 126 A320-family NEOs. These are state-of-the-art jets that will serve it well as it simplifies and downsizes. 

The carrier does point out that even pre-crisis, it was moving away from its overreliance on premium business demand, reducing the size of its longhaul premium cabins for example (most of its U.S. rivals were doing the opposite). On many aircraft, it removed first-class cabins. Separately, executives hinted that its five hubs, all located relatively close together, might be too many. Many of its largest connecting traffic flows, it said, can be handled by any of its hubs (think flows between say, Milan and New York, which can go through Frankfurt, Munich, Zurich, Vienna, or Brussels with similar ease).

Lufthansa admits that the pace of its own recovery will depend a lot on the health of the critical transatlantic market, where it works closely with United and Air Canada. Naturally, Japan and China are major markets too, served in partnership with ANA and Air China. It works closely with Singapore Airlines as well. The troubles of leisure-oriented rivals like Condor and TUI will help, though they too received lots of government help. Eyes will be upon the continent’s three top LCCs — Ryanair, easyJet, and Wizz Air — to see what they have planned post-crisis for the German and Austrian markets.

Lufthansa, meanwhile, hopes to redefine its relationships with airports, air navigation providers, and aircraft suppliers, demanding they share the burden of rebuilding from the industry’s greatest-ever demand shock. Its relationship with Germany’s government, of course, is already thoroughly redefined. But the most important negotiations of all — with labor unions — is the next big focus. No, it won’t be alone in having to ask its workers for deep concessions. But that’s small comfort for an airline with big problems.

Lufthansa’s Margins