European majors:
Triple Peaks March 2018

Nearly ten years on from the peak of the last cycle, the major European network carriers are finally producing healthy returns. In the depths of the downturn following the global financial crisis, each of the top three groups put in place plans to return to a sustainable level of profitability by 2015. Things don’t always work to plan, but finally in 2017 IAG delivered a return on invested capital of over 16% (above its 15% through-the-cycle target) and the Lufthansa Group its highest ever result with an operating profit of €3bn and return on capital of 11.6%. Even Air France-KLM managed to achieve an operating profit of €1.5bn, a margin of 5.8% and a nominal return on capital of 11%. What now?

In the last few weeks each of the European major network groups — IAG, Lufthansa Group and Air France-KLM — published results for 2017 showing a strong improvement in returns. If there is a common thread it is: the three major players' mainline carriers — British Airways, Air France and Lufthansa — maintained what is referred to as capacity discipline, while pushing growth to lower cost subsidiaries; unit revenues rose faster than unit costs across each of their subsidiary airlines; margins improved; there was a long anticipated recovery in cargo operations; and all have embraced the latest industry fad of starting long haul low cost operations.

IAG — leading the pack

IAG — incorporating British Airways, Iberia, Aer Lingus and Vueling — saw revenues grow by a modest 2% to €23bn and adjusted operating profits increase by 19% to €3bn. This was on the back of a 2.6% growth in total capacity, a 3.8% increase in passenger demand and unit revenues up by 1.8% in constant currency terms against a unit cost decline of 0.2% on a similar basis. Underlying net profit improved by 13% to €2.2bn.

IAG is the smallest of the three majors in terms of revenues and total traffic, but it is the most profitable. At the group level it achieved an operating margin of 13% — with margins of over 14% registered at the Anglo-Saxon entities of British Airways and Aer Lingus.

At BA capacity was up by only 0.7%, traffic grew by 1.5%, unit revenues increased by 6.4% against a unit cost growth of 4.7%. The airline registered an operating profit of £1.5bn up by 19%. Following Sterling devaluation in the wake of the Brexit vote, in Euro terms operating profits only grew by 10%. The group states that it achieved a return on invested capital of 16% — possibly one of the best in its history.

Iberia saw capacity growth of 2%, traffic growth of 4.8%, unit revenues up by 3.5% but unit cost increases limited to 1.4%. As a result revenues improved by 6% and operating profits jumped by 40% to €376m. RoIC came in at 12.2%, a tad below the group target of 15% but above the previous year level.

Aer Lingus continues to perform extraordinarily: for British Airways it could be said to be providing at Dublin the third Heathrow runway. Capacity and traffic was up by 12% in the year as it continues its expansion on the Atlantic. Unit revenues were down by 6% but unit costs fell faster at 7%. Revenues were up by 5% and operating profits by 15%. The airline achieved a 23% return on invested capital.

Vueling should perhaps have been doing better. But it had some severe operational problems in 2016, and in 2017 went into recovery mode. It increased capacity by 1.5%, demand by 3.8%, unit revenues by 1.5% and cut unit costs by 4.8%. Revenues were up by 3% to €2.1bn and operating profits touched €188m, triple the level of the previous year. Its RoIC of 13% for the year is also below the group targets.

There were no real details on the new long haul low cost operation — Level, currently operated under the Iberia AOC — but the management have stated that it is already profitable (ex start-up costs), and project that it will get to IAG’s RoIC target of 15% “by maturity”. This is no doubt a response to the first-mover Norwegian in the fear that LHLCCs will actually work. It started with two high density A330s (293 economy and 21 premium economy seats) out of Barcelona to Buenos Aires, Oakland and Punta Cana last summer and carried more than 155,000 passengers in its first seven months — it also has the advantage of potential feed from Vueling at Barcelona. It will add three more aircraft in 2018 and a new base at Paris Orly (using the group’s OpenSkies AOC) opening routes to Guadeloupe, and Montréal in July; Newark and Martinique in September. The group plans to increase the fleet to at least 15 aircraft by 2022.

On outlook, management was quietly positive. It is looking to increase group capacity by nearly 7% in 2018 — +3% at BA, +9.7% at Aer Lingus, +7.5% at Iberia and +12.5% at Vueling — and expects operating profits in 2018 to “show an increase year on year”.

Lufthansa Group — best ever results

2017 was a transformational year for the Lufthansa Group. Firstly, they acquired majority control of Brussels Airlines, which added 5% to the revenue base, and consolidated it in the Group financial accounts from January. Secondly, a wet-lease deal for 30 A320s with the failing Air Berlin, and then its subsequent bankruptcy gave a significant boost to the Eurowings operation.

Total capacity in 2018 grew by 12.7% (and 19% in Europe), demand by 15%, unit revenues by 1% while unit costs fell by 1.6%. Total revenues increased by 12% in the year and underlying operating profits jumped by 70% to €3.0bn — reflecting a group margin of 8.4% and a return on capital of 11.6%.

This operating profit improvement was felt across all the subsidiaries. Lufthansa itself saw operating results increase by 43% to €1.6bn, Swiss by 31% to €542m and Austrian by 62% to €94m, while the cargo operation rebounded into profitability with operating profits of €242m and a margin of nearly 10%. “Point-to-Point Airlines” (which includes Eurowings, Brussels and SunExpress, its joint venture with THY) saw revenues double to €4bn and reversed prior year losses of over €100m to an operating profit of €94m in 2017.

Another milestone in 2017 was the conclusion of a long term collective agreement with the Vereinigung Cockpit union, which among other things agreed to a 15% “structural” reduction in flight crew costs at Lufthansa mainline, the move to a defined contribution pension scheme and — importantly — the removal of previous restrictions on growth at “lower cost” units.

Meanwhile, the competitive landscape in Lufthansa’s teutophonic home territory has changed dramatically with the demise of Air Berlin. easyJet has become the largest operator at Berlin, having acquired the Air Berlin operations at Tegel — and is even starting to operate domestic flights on the main trunk routes. Niki Lauda has reacquired Air Berlin’s Vienna-based Niki (which Lufthansa had wanted to acquire but was denied by the competition authorities) with 15 A320s, rebranded it as Laudamotion and brought in Ryanair as an initial 25% (and potential 75%) investor.

Lufthansa was allowed by the competition authorities to acquire Luftfahrtgesellschaft Walter — Air Berlin’s “lower cost” regional subsidiary — which it incorporated into Eurowings at the beginning of January. It is through Eurowings that it clearly sees growth potential.

The fleet in operation has grown from 80 in 2015 to 152 at the end of last year, with plans to build to over 210 by 2019. Eurowings is not exactly low cost — its unit costs of 7.8€¢/ASK are some 50% higher than easyJet’s (on a slightly higher stage length) and more than double those of Ryanair — although the group plans to be able to reduce underlying unit costs by 5% a year over the next three years. It doesn’t exactly adhere to the low cost KISS principal either: it has a series of AOCs, multiple aircraft types — complicated by Q400s from the LGW acquisition — and multiple arrangements to provide lift through wet-leases (including from Laudamotion).

It is difficult to see what Lufthansa’s ultimate plan is. The stated aim is to make Eurowings the number one point-to-point airline in its German speaking home countries. It could be a way of transferring its own high costs into a slightly lower cost platform. It may be that it wants to emulate the way that Qantas has developed Jetstar as a long term attempt to show the unions who runs the airline. It could even be a viable second brand that does not cannibalise traffic from the mainline operations.

On outlook for 2018, management were more sanguine than their counterparts at IAG. They expect total group capacity to rise by 9.5% in 2018, with the network airlines growing by 5% and Eurowings by over 30% (half of which comes from Air Berlin' failure), unit revenues to be stable, ex-fuel unit costs to fall by 1-2% but a €700m increase in the fuel bill. Operating profits they expect to be slightly down. For cultural and local legal reasons Lufthansa tends to be conservative on earnings outlook, this means they realistically expect profits to increase a bit.

Air France-KLM — recovering

It has been a long process, but Air France-KLM finally in 2017 produced a reasonable level of profitability, although it is still a long way behind its peers. During the year, revenues grew by 4% to €25.8bn and adjusted operating profits jumped by 42% to €1.5bn (a 6% margin) — finally exceeding the operating result at the peak of the last cycle in 2007-08. Underlying net profits came in at €1.2bn, although a charge relating to the derecognition of KLM flight crew pension plans pushed published net results to a €274m loss. Total group capacity was up by 2.4% and unit revenues by 1.4% while unit costs fell by 0.3%.

As for results by carrier, Air France saw total revenues up by 2.5% to €15.9bn and operating profits up by 58% to €588m — still a paltry 3.7% margin — while the smaller KLM continued to outperform with a 5% growth in revenues to €10.3bn and a 34% jump in operating profits to €910 — a respectable margin of 9% and nearly twice the absolute amount generated by the French flag carrier.

Transavia continues to grow rapidly and increased capacity by 11%, demand by 12%, unit revenues by nearly 7% while unit costs increased by only 0.7%. As a result total revenues improved by 18% and the operation leaped into profit delivering an operating margin of 5.6%.

The Group made significant further progress in reducing balance sheet risk. The ratio of adjusted net debt (which includes a capitalisation of off-balance sheet operating leases) to EBITDAR has fallen from 5.7 times at the end of 2011 to 2.1x at the end of 2017 (the debt/equity ratio has been virtually meaningless). This was helped last year by operating free cash flow of €0.7bn, soft call exercise of a €500m convertible bond, and an equity infusion of €747m from Delta and China Eastern (each taking 10% and acquiring a seat on the board). Net debt fell in 2017 by around €2bn to €1.7bn. Air France-KLM will be adopting FRS16 (on the treatment of leases, which will bring operating leases onto the balance sheet) from the beginning of 2018, a year earlier than necessary, which ironically seems to be set to reduce adjusted net debt by a further €2bn.

The equity infusion from Delta and China Eastern was sort of necessary to allow Air France-KLM to buy a 31% stake in Virgin Atlantic from Richard Branson for £220m and fuse the two trans Atlantic joint ventures — although how this will survive Brexit is puzzling. All this has helped to double equity on the balance sheet to €3bn.

Air France has also set up a new carrier branded as low cost called Joon (supposedly to appeal to the young). It started operations from Roissy CDG in December on short haul leisure routes and plans to start long haul operations wet-leasing aircraft from the Air France mainline. Its growth is limited by agreement with the company’s unions, is unlikely to be truly low cost, and will probably be a poor answer to the competitive threats from Norwegian, Primera, French Blue and Level.

Meanwhile, industrial relations at Air France, have taken a turn for the worse (if possible) with strikes planned over the Easter period. Ten of its plethora of unions (pilots: SNPL, Spaf, Alter; cabin crew: SNPNC, Unsa-PNC, CFTC, SNGAF; and ground staff: CGT, FO and SUD) said: “We are hardening our movements” in the face of management who is “giving no concrete response” to “our demands” (for a 6% increase in salaries), and is “standing firm and seeking division”.

The management offered little guidance on the outlook for the current year, save that early signs showed a continuation of a positive trend, that the network carriers would increase capacity by 3-4% and Transavia twice as fast, and that underlying unit costs were expected to fall by 1-2%. They expect to outline a new medium term plan and new financial targets on the publication of the first quarter results.