Euro-Majors: IAG leads, Lufthansa unifies,
Air France reforms Jul/Aug 2019

Over the past month the three top European network carriers, IAG, Lufthansa Group and Air France-KLM, have published their first half 2019 results. There are clear differences, but the figures show a strong element in common: unit revenues are under pressure, but unit costs even more so.

As a group, total capacity and revenues grew by just under 5% year-on-year but operating profits slumped by 36%. A main reason behind this was an fuel prices: the total fuel bill was up by 18% year-on-year. This reflect the fact that 2019 fuel supplies were bought at, or hedged at, 2018 prices. Since then the spot price of oil has fallen (-15% on an annual basis in August) but this decline has not benefited airlines as yet.

As the chart shows, on a twelve month rolling basis, IAG has maintained a run-rate in group operating profits at around the €3bn level since mid-2017; Air France-KLM has seen profitability dip slightly over the same period but in broad terms flat-lined at the €1bn level; while the Lufthansa Group has seen group operating profits down by a third.

IAG — leading the pack

IAG is the smallest of the three in terms of total group revenues but by far the most profitable. In many ways its first half results showed a process of“continue as normal”.

Group revenues were up by 8% to €12bn with total capacity up by 5.7% while unit revenues increased by 1.3%. Total fuel costs touched €2.9bn, 20% higher than in the prior year period, and with non-fuel unit costs up by only 1.3% operating profits before exceptional items were some 12% lower at €1.1bn. The second quarter itself showed some positive notes with operating profits up by 6% to €960m.

Each of the four main airlines in the group (British Airways, Iberia, Aer Lingus and Vueling) saw operating profits down in the first six months — the company had neglected to separate the individual airline results in the first quarter (when only British Airways had a positive operating margin) — but the management notes that results were “strong” in the three months to end June, and that RoIC on a trailing twelve month basis showed improvement at both Iberia and Vueling and at the group level remained above its 15% target. The fifth airline in the group — Level — does not report results separately and for the moment is consumed within Iberia.

IAG is unique. Late to the consolidation game, it was able to create a structure in the 2011 merger between BA and Iberia that avoided the mistakes it saw in the creation of its rival European groups. The two legacy network airlines in its portfolio each have strong positions in their home markets in London and Madrid; the LCCs — Aer Lingus, Vueling and Level — provide it with growth potential that seems divorced from cannibalising its network carriers' traffic. One limitation on expansion may be that Vueling’s AOC requires its pilots to speak Spanish.

Further, the holding company maintains a strong discipline as the arbiter of the allocation of capital to its operating subsidiaries according to the returns each can achieve to maintain a corporate target of a sustainable 15% RoIC.

Alone among the three majors IAG saw no reason to change its former guidance that full year operating profits would be similar to those of 2018.

The stock markets however have not treated the group kindly, with the shares down some 60% from its peak of £7.27 in mid 2018. A large part of the reason behind this is the extreme uncertainty over Brexit and the increasing likelihood of the UK leaving the EU at the end of October without a deal in place.

EU airlines must be able to show that they are majority owned and effectively controlled by EU nationals (or governments). Like many other listed airline groups IAG has provisions in its by-laws permitting it to limit non-EU shareholders. In February, the group invoked this provision as non-EU shareholders had broached 47.5% of the total, and as a result MSI removed IAG from its global indices.

IAG’s CEO, Willie Walsh, is adamant that there is no problem and states that the regulators in each of Spain, Ireland, France and Austria have confirmed that IAG’s airlines in those countries would satisfy the EU ownership and control requirements in the event of a no-deal Brexit. But the structure set up in 2011 plays its part:

• IAG is a holding company that owns share in airlines. It is not an airline.
• Both BA and IB were merged into IAG in its formation with a legal backstop that“proves” that each is majority owned and controlled by nationals of their home countries. Therefore IB is Spanish and ergo European and BA is British and non-European post Brexit. The UK is abandoning the ownership and control restrictions and turning to a definition of a national carrier as one with its principal place of business based in the UK. If this works for these two, similar legal workarounds can be installed for all its other airlines.
• The EU interpretation of “ownership” relates to common equity and seems to have no understanding of real “control” in that it has implicitly allowed the Wizz Air ownership structure where Indigo (a US investment company) has had board control and majority capital investment but minority of the direct common equity; AirBerlin and Alitalia remained “European” despite Etihad’s obvious “control”.
• The EU has historically allowed Monarch (Swiss owned) and Thomson (Canadian) to be treated as European.
• If all else fails IAG may be able to persuade Qatar (which owns 20% of IAG) to place its IAG holding into a European based investment fund. (The EU is blinded by its view of legality, and can only consider the nationality in which an investment is legally based).

The unknown and rather important detail is how IAG will have to treat its UK shareholders.

Lufthansa Group — unifying Germany

Lufthansa meanwhile published results for the first six months sharply down on the previous year. Revenues grew by 3% to €18.2bn on the back of a 4.7% growth in capacity and a 1.6% decline in unit revenues. Total fuel costs rose by 16% to €1.8bn, unit costs excluding fuel grew by 2.5% and total group operating profits slumped to €418m down from €1.05bn.

Among its individual airline brands Lufthansa saw its own operating profits fall by two-fifths to €403m and Swiss by a relatively modest 25% to €215m; but Austrian dipped into an operating loss of €53m from a profit of €5m in the prior year period and Eurowings managed to generate an operating margin of a negative 14%, and a mammoth operating loss of €273m (€220m).

Lufthansa is fiercely protective of its position in its core teutophonic markets in Germany, Austria and Switzerland. The demise of Air Berlin allowed it to consolidate non-hub domestic German flying into its“Low Cost” subsidiary Eurowings.

However, Eurowings is not really low cost — with a unit cost at legacy levels (see table) and an unwieldy and complicated structure of multiple AOCs. It even managed to achieve a negative operating margin of 7.8% for the full year 2018 (see chart).

Secondly the demise of Air Berlin allowed easyJet to gain significant presence in Berlin Tegel, and spurred accelerated development of services by Laudamotion (aka Ryanair), Level, Wizz and Vueling at Vienna. This it appears has had a deleterious impact on yields at Vienna with the disastrous impact on Austrian seeing unit revenues fall by 7.4% in the period.

All this has prompted Lufthansa to make a strategic volte face. Eurowings will revert to be a short haul point-to-point airline, cancelling long-haul flights and restricting capacity growth.

The restructuring of Eurowings is paramount. Having increased capacity by an average annual rate of 19% since 2015, eliminated losses on the old Lufthansa non-hub flying but generated significant losses on the integration of the Air Berlin business, current plans point to capacity growth of a mere 1%pa up to 2022, a streamlining of the business to have a single AOC, simplification of the fleet structure removing turboprops, wet-leases and aged aircraft, and intriguingly a reduction in unit costs towards an almost LCC level of 5.2€¢ by the end of that year.

Brussels Airlines will come out from under the Eurowings umbrella (why they thought it would fit in the first place is incomprehensible). Since Lufthansa acquired majority ownership in 2017 the performance and results have not been separately disclosed. But it remains structurally loss-making, and provides little benefit to the group’s multi-hub network strategy, with the exception of some routes possibly into francophone Africa; and no doubt is a distraction to Eurowings' point-to-point and single AOC strategy. Recent Belgian press comments suggest that the Belgian flag-carrier also is about to undergo major restructuring.

On the Q2 results’ conference call the management emphasised that “yields in Europe, particularly in Germany and Austria remain under pressure, because of market-wide overcapacities, aggressive competition and increasingly price sensitive demand”, and that it expects the condition to continue for some time. It “will fight off” the LCC competition to protect its core markets.

Lufthansa held an investor day in June. There had been some hopes that the group would look to realign its corporate structure to mimic that of IAG: a holding company that impartially looks to returns from its subsidiaries and allows them to compete for capital. But, the management saw significant legal complexity in trying to restructure Lufthansa AG to achieve that. There had also been hopes that Lufthansa would consider reducing capital intensity by increasing the ratio of leased aircraft in its fleet.

Fat chance: Lufthansa likes to own aircraft — only 6% of its 763 strong fleet at the end of 2018 were leased. However, it is in the process of a major spending spree. Its current fleet plans suggest that it will acquire 234 new aircraft by 2023 but in the process retire 220 leaving a net addition of 32. This will bring substantial improvements to the fleet structure and fuel efficiency: it will be trimming the number of fleet types in the long haul fleet from 14 to eight; it has ordered 128 A320/A321neo for the short haul fleet with a single common specification (in the past it has had 28 separate subfleet types).

This refleeting will cost. Capex will be rising from the current €3.5-€4bn a year, and some analysts have expressed doubts that the group will achieve its target of €1bn free cash flow before 2022. But the group has signalled its intention to sell its catering arm LH Sky Chefs.

Air France-KLM — the Smith era

Similarly Air France-KLM produced a disappointing first half result. Group revenues grew by 4.9% to €13.0bn, but operating profits fell to €97m from €228m in the prior year period: fuel costs had risen by 16% to €2.6bn. And this was in spite of a comparative period last year with substantial strike action at Air France.

The French flag-carrier itself saw capacity up by 5% and an increase in revenues of nearly 7%, an improvement in operating margins of 1.4 percentage points but still produced an operating loss of €113m. In contrast, KLM’s result were sharply down at €202m because of the increase in fuel prices: capacity was flat and unit revenues marginally up. The group’s low cost arm Transavia gained a near 9% increase in revenues on a 10% growth in capacity but operating losses reached €19m, an off-season negative margin of 2.5%.

The Franco-Dutch group has been seen as the sick man of the European airline sector since the global financial crisis in 2008. But maybe things are about to change.

In August last year the group appointed a new CEO — Ben Smith — remarkably a Brit, ex-Air Canada, and not an alumnus of ENAC. He was charged with the task“as a priority to revitalise Air France, to give a new strategic impulse to the Group and to work on a new leadership approach with all Air France-KLM’s teams”.

He acted quickly. By October he had managed to agree a pay deal with the Air France cabin crew and ground staff unions; in January he killed off the Joon project (an ineffectual and ill-thought attempt to introduce B-scale wage structures through establishment of a new airline brand); in February he managed to come to an agreement with the belligerent SNPL pilots' union; and in July managed to get the French unions to agree to lift the cap of 40 aircraft in the Transavia France fleet, and remove limits on stage length use of narrow body aircraft in the Air France operations.

What his actual strategy is is as yet unclear. The Group will be holding a capital market’s day in November where all may be explained. In the meantime the Q2 results' presentation gave a few clues of the direction — with an emphasis on simplicity.

Air France’s short haul fleet is aging — by 2024 half of the fleet of A320 family aircraft will be more than 20 years old — and is in need of replacement. As a start the group announced an order for 30 new A220s plus 20 options, presumably to replace its A318s and A319s. This will be a slightly lower capacity aircraft but one with higher efficient range and may prove a better fit for the feed requirements to the hubs at Roissy and Amsterdam.

Secondly, the group is simplifying its existing long haul fleet: it will reduce the number of 777 subfleets from seven to three, will dispose of the remaining five A340s in the next two years and standardise the configuration of other types. It has further decided to simplify the structure at the individual brands: KLM will take Air France’s 787 orders and Air France KLM’s A350s. In addition it announced that it will dispose of its 10 A380s by the end of 2022 (by which time they will have an average age of just over 10 years), avoiding expensive product upgrade and mid-life maintenance costs, replacing them with no more than nine new generation wide-bodies (with fewer seats and lower trip-costs).

The company did not address its plans for its French domestic and non-hub point-to-point network, which remains heavily loss-making, saying that it hasn’t fully decided yet. But Ben Smith summarised the corporate thinking by saying: “The A220 is a great tool. HOP! needs to be restructured. Our position at Orly is key and the future number of aircraft we can operate at Transavia all plays into how we will optimise the French market.”

Much of the comment at the Q2 results conference referred to Air France, with little mention of KLM. One further issue the Group has yet to address is that of corporate governance. In February, the Dutch government bought a 14% stake in the Air France-KLM group, which it said it viewed as a “fundamental step towards protecting Dutch interests”. This came as a surprise to the French Government which has a similar stake — but, because of the Florange law (which gives double voting rights to long term shareholders) the French state has 23% of the voting rights, and the Hague will have to wait to 2021 to achieve parity.

Perhaps the new CEO’s progress so far has been the easy bit.