Can Consolidation Lift Lufthansa?
Who remembers this? In 2007, just before the global financial crisis, the Lufthansa Group purchased a 16 percent ownership stake in JetBlue Airways. The idea: To establish greater influence in New York, America’s largest airline market. Ultimately, the move proved much ado about nothing. Lufthansa’s close partner United Airlines would merge with Newark powerhouse Continental Airlines in 2010, giving the German giant all the Big Apple bulk it needed. In 2015, it quietly sold its JetBlue shares, consigning the investment to a forgettable footnote of airline history.
Fast forward to 2022, and Lufthansa is again contemplating an investment in a foreign airline. This time it’s Italy’s ITA Airways, the successor of longtime laughingstock Alitalia. Lufthansa has teamed with the shipping giant MSC to buy 80 percent of ITA, thus providing more clout in the large Italian market — Western Europe’s third largest. During Lufthansa’s second quarter earnings call, CEO Carsten Spohr called Italy the group’s “most important market beyond our home markets.” He’s alluding to the rich vein of corporate traffic sourced from Italy’s wealthy northern regions, funneled through the airline’s primary hubs in Frankfurt, Vienna, Zurich, and especially Munich. “We need a stronger position in Italy, one way or another,” he said, “hopefully together with ITA.” If an ITA deal doesn’t happen? Lufthansa will grow its own Italian airline, Verona-based Air Dolomiti, of which it holds 100 percent control.
Make no mistake. Lufthansa looks west with envy, mindful of how major mergers have introduced financial stability and strength to the once-chronically-ill U.S. airline industry. Europe, by contrast, remains highly fragmented, not just within the continent but also on intercontinental routes. Lufthansa has certainly done its part to help address the problem. Since 2005, it’s built itself an empire of airlines. One has been a diamond — its takeover of Swiss, most importantly, was one of the greatest airline acquisitions of all time, yielding profit margins consistently higher than the Lufthansa-branded airline itself. Some, on the other hand, have been duds, including Austrian, Brussels, and Eurowings, all with loss-making histories.
On balance, this consolidation hasn’t created a platform for strong groupwide profitability. From 2015 to 2019, a half-decade with rather lowish average fuel prices, the group earned just a 6 percent operating margin on roughly $200 billion in revenues. Its partner United, during that same period, did twice as well: A 12 percent operating margin on essentially the same amount of revenues.
Maybe ITA and a stronger Italian franchise might get Lufthansa closer to U.S.-like profit margins. It’s surely keeping at least one eye on events in Scandinavia, where the bankruptcy and labor woes of SAS create more leverage to potentially strike (pun intended) an advantageous takeover deal. Markets like Denmark, Norway, and Sweden are somewhat less well positioned than Italy for feeding traffic into Lufthansa’s main hubs. Also, unlike Italy, long a SkyTeam-dominated market, Scandinavia is already Star-affiliated, limiting the upside of a SAS takeover. In addition, SAS doesn’t have any unique geographic niches, like Brussels does in Africa or Austrian does in eastern Europe and the former Soviet Union. SAS doesn’t even dominate its home hubs, with Copenhagen, Oslo, and Stockholm infested with low-cost competition. Still, there’s gold in them hills — Scandinavia is a wealthy market with an abundance of globetrotting corporate traffic. Might wealthy Scandinavian travelers do for Lufthansa, what Switzerland’s wealthy travelers did for it? On the other hand, might SAS be merely another headache for Lufthansa, like Austrian and Brussels have been?
Lufthansa now talks about a new post-pandemic normal for the industry, which it foresees featuring a “higher level of consolidation.” That presumably includes consolidation undertaken by others. It likely means overseas joint ventures as well, like Lufthansa has with United and Air Canada across the Atlantic, and with Air China, All Nippon Airways, and Singapore Airlines to East Asia.
Lufthansa, to be sure, is taking other steps to achieve more robust profit margins — its goal, by the way, is an operating margin of at least 8 percent by 2024. One critical piece of reform involves its fleet. Lufthansa gets no prizes for aircraft strategy. In decades past, it bet wrongly on four-engine passenger jets like the Airbus A340 and A380, and the Boeing 747-8. It watched with envy as Air France wisely made the Boeing 777-300ER the centerpiece of its longhaul fleet — only very late did Swiss add a handful of -300ERs, which by all accounts have served it extremely well. Having learned its lesson on twin-engine widebodies, Lufthansa was an early buyer of Boeing’s 777-9. Alas, that’s a plane few others seem to want, arguably destined to become another A380; i.e., a plane with too much capacity, too much complexity, not enough new technology, and overlapping in capabilities with some of Boeing’s own 787, including the extended range 787-10 that it plans to build.
Dreamliners, to be sure, are part of Lufthansa’s long-term fleet plan as well — it ordered them later than most, but better late than never. It’s also betting on Airbus A350-900s. And with respect to narrowbodies, Airbus A320 family and A220 aircraft dominate. That’s a path toward helpful fleet simplification. And besides, even those 777-9s will in fairness be more useful to Lufthansa than others given the jet’s promising cargo capabilities.
Cargo is hardly an afterthought. It’s what saved Lufthansa from a much grizzlier fate throughout the pandemic. It’s also a business that produced a spectacular 38 percent operating margin last quarter, contributing about 15 percent of the group’s total revenues and $600 million in operating profits. Without that contribution, the group would have lost money in the second quarter.
Indeed, total operating profit for the quarter was just $491 million, good for a mediocre 5 percent margin. The robust demand recovery notwithstanding, the Lufthansa-branded passenger operation suffered a negative 2 percent margin. Eurowings, still not healthy after countless restructurings, delivered a negative 14 percent margin. The similarly troubled Brussels came in at negative 9 percent. Austrian managed to rise just above breakeven. Conversely, Swiss again was a success, matching KLM for best airline operating margin in Western Europe last quarter: 9 percent. The group’s giant aircraft maintenance division — with more revenues than either cargo or Swiss last quarter — did well too with a 7 percent margin.
Enacting structural changes across such a multivariate empire isn’t easy. But Lufthansa hopes to use complexity to its advantage in at least one respect. Having so many different airlines is a tool it can use to arbitrage labor costs. During its second quarter earnings call, management made it perfectly clear it would never move to uniform pilot pay across the group, even within Germany. “To come to one overall pay scale system for all the airlines in Germany is, for us, a strategic no-go,” Chief Financial Officer Remco Steenbergen said. “We cannot do that because that will really put our company at such a strategic disadvantaged position against the other airlines.” Having different pay scales under one corporate roof is not something practically possible in the U.S. given labor-management circumstances there. Of course, this labor arbitrage game is one Lufthansa has been playing for years, most notably in its development of Eurowings.
Even so, Eurowings has repeatedly lost money, despite its lower labor costs, and some favorable pre-pandemic competitive developments, like the collapse of rivals Air Berlin and Thomas Cook. The ineffectiveness of Eurowings stems from multiple shortcomings, including its operational complexity. The LCC began life as Germanwings, established to handle point-to-point shorthaul traffic that didn’t touch the group’s Frankfurt or Munich hubs. Over time, it morphed into a new platform called Eurowings, added longhaul flying, took responsibility of Brussels and Sun Express Germany, inherited the assets Lufthansa purchased from Air Berlin, refocused on hub flying, and so on. Most recently (July 2021), the group launched yet another iteration of Eurowings, this time called Eurowings Discover, modeled on Swiss’s successful leisure subsidiary Edelweiss and focused on longhaul and shorthaul leisure flying from Frankfurt and Munich. The core Eurowings (now simplified with fewer operating certificates) remains focused on serving passengers based in non-hub cities, most importantly Dusseldorf. Keep in mind that Germany has a much more decentralized economy and population than either Paris-centric France or the London-centric UK.
This decentralization helps explain why roughly 70 percent of Frankfurt’s airport traffic is connecting, compared to just 50 percent for Paris Charles de Gaulle and 30 percent for London Heathrow. This dependence on transfer traffic requires lots of shorthaul flying to support longhaul flying. The problem is, shorthaul flying is a bloodbath for European airlines not named Ryanair, EasyJet, Wizz Air, or, for that matter, the successful low-cow cost platforms developed by International Airlines Group (Vueling and Iberia Express) and Air France-KLM (Transavia). Eurowings ears many scars from assaults by LCCs like EasyJet.
As Spohr pointed out in the group’s second quarter earnings call, Germany now accounts for just 30 percent of total ticket sales. The majority of its 11 airline operating certificates, furthermore, are based outside of Germany. That’s somewhat comforting as Germany faces a difficult time economically, challenged by unsettling exposure to Russian energy and overseas exports (of autos especially, many sold in China). But selling outside of your home market is always more challenging than selling from within. That’s why sales help through international joint ventures — as well as control of markets like Austria, Switzerland, and perhaps Italy via acquisition — is so appealing. European loyalty plans, remember, simply don’t have the influence and reach they do in the U.S. Lufthansa’s Miles & More program has a mere 35 million members compared to United MileagePlus’ 100 million.
As it surveys the new realities of post-pandemic travel, Lufthansa is pleased to see premium demand perform well. It often claims to have more premium seats flying than any other airline, including premium economy seats which are performing extremely well this summer. On the other hand, it’s less exposed to leisure traffic than most global carriers, with Germany, Switzerland, and Austria attracting many fewer tourists than countries like France, Spain, the UK, and Italy. Lufthansa has historically had more Russia exposure than either Air France-KLM or IAG. It has more Asia exposure as well, currently a liability. China, in particular, is a market where Lufthansa invested heavily under its Air China joint venture. Just prior to the Covid shock, according to Cirium schedules, the Lufthansa Group served five cities in mainland China from Frankfurt, as well as Beijing and Shanghai from Munich, Vienna, and Zurich. Will demand to support those routes ever come back?
What should come back, if not entirely, is Lufthansa’s lucrative international corporate traffic. During the first quarter of this year, it flew just a fifth or so of its normal level of corporate travelers. That doubled to around 40 percent by June. Based on bookings, that’s moving to more like 50-60 percent of pre-crisis levels in the third quarter. Management targets a 60-70% recovery by year-end, and a new normal of about 80 percent, factoring in expectations that some corporate demand will be permanently lost to video conferencing and other new work practices.
This summer, the more immediate issue is stabilizing operations after a tumultuous spring. “For the complex air traffic system,” said Spohr, “the ramp-up curve from just 20 percent to 80 percent in just a few weeks, to be honest, was just too steep.” He added: “The overload of the system was caused by industry-wide staff shortages and on top, partly caused by … high sickness rates.” The Russian airspace closure added further complications, as did a shortage of aircraft and spare parts. Lufthansa has faced labor unrest too, leading to new contracts for ground workers. And, like most airlines, the group faces the problem of asset-underutilization in advance of having all its pre-crisis capacity restored.
On a more encouraging note, Lufthansa is well-hedged on fuel. An exodus of senior pilots and other workers heralds downward momentum in labor costs through juniority (long-tenured airline staff earn much more than newcomers). The many airlines in the group enable management to play a game of carrot and stick, delivering capital and capacity growth to successful subsidiaries, and the opposite to those that lose money. Sure enough, Cirium seat capacity figures show Swiss grew 19 percent from 2005 to 2019, while Lufthansa mainline grew just 9 percent. Interestingly, Austrian, Brussels, and Eurowings grew even faster as executives sought to push more production to the lowest-cost platforms. But as financial results show, this hasn’t been a recipe for higher margins.
To achieve that, Lufthansa will next turn to a revamp of its inflight premium products — stay tuned for announcements this fall. In the meantime, strength in the critical transatlantic market this summer should help keep cash flowing in, enabling the repayment of state aid provided early in the crisis. Lufthansa plans to divest a stake in its maintenance unit, while selling off its travel payments and catering businesses. The carrier’s first 787 should arrive soon now that deliveries have resumed (see Fleet). Importantly, emergency cost cutting during the pandemic lowered the company’s fixed cost base by more than $3.5 billion. Close cooperation with Germany’s passenger rail operator Deutsche Bahn should provide more connecting traffic while advancing environmental goals. Digitalization, personalization, direct distribution, reduced complexity, corporate simplification, and sustainability are all priorities.
The most important factor shaping the future of Lufthansa’s profitability, however, might very well be the consolidation it so craves. As its latest annual report states: “Although the pace of consolidation in the airline industry has slowed temporarily but significantly as a result of the coronavirus crisis, the Lufthansa Group still aims to drive the consolidation of the airline sector.” Let’s see what happens in Italy.