Lufthansa state aid: How difficult can it be
to give away €10bn? May/Jun 2020

Lufthansa Group entered the current crisis as well-prepared as could be expected from any airline. Its finances were in good shape, and the future had been looking rosy.

In 2019 revenues in 2019 had grown by 2.5% to a record €36.4bn. While profitability had been under pressure from increases in fuel prices and intense competition in Vienna, the group still managed to report an operating result of over €2bn and a margin of 5.5%. Within this, the network airlines — Lufthansa, Swiss and Austrian — achieved respectable margins of nearly 8%, while losses at the point-to-point Eurowings airline subsidiary had been cut by more than a quarter to a mere €-166m.

Indeed the restructuring measures the group had put in place for the short haul operation seemed to be starting to work. These measures included simplifying the plethora of AOCs into a single one in Germany; placing long haul "touristik" routes, and realigning Brussels Airlines into the Network Airlines division; modernising and harmonising the fleet; concentrating on simplicity, improving crew and aircraft productivity. All looked set to allow Eurowings, now Europe’s third largest point-to-point airline (behind Ryanair and easyJet) to aim for break-even by 2021 and achieve long term margin goals of 6% a year.

At the 2019 capital markets day, CEO Carsten Spohr reiterated the group’s prime corporate strategy message to be the #1 for all stakeholders, committed to drive sustainably higher returns: for customers (“there is no better way to fly”); for employees (“there is no better place to work”); and shareholders (margins and return on capital doubled since 2014, free cash flow to exceed €1bn a year in the medium term, and dividends of up to 40% of net income).

Coronavirus crisis shattered all rosy plans.

Lufthansa was one of the first airline groups to react decisively to the pandemic. On the announcement of its annual results at the beginning of March, having seen a dramatic plummeting of demand in a matter of a mere fortnight, it effectively grounded the majority of its fleet and cut flying capacity by 95%.

But Lufthansa, despite its natural conservative accounting tendencies, had one of the lowest levels of available liquidity of all the large European carriers as it entered the crisis with only €4.4bn of cash and equivalents (almost entirely funded by advance ticket sales). In grounding the fleet it could avoid variable costs (60% of the total) and has worked hard to try to slash its fixed costs as much as possible. Even with these efforts, as Carsten Spohr pointed out at the group’s virtual AGM at the beginning of April, the group was burning through cash at the rate of €1m an hour (or €700-800m a month).

At the same time, because of its very conservative nature, it had one of the lowest level of leased aircraft in its fleets (115 planes out of a total fleet of 744), perhaps relying on the idea that, if necessary, it would be able to raise cash on its unencumbered assets. A low level of leased equipment has certainly reduced the level of monthly cash obligations, but the policy has not provided flexibility in a crisis. Various major carriers have been able to raise funds backed by aircraft since the onset of the crisis (notably Qantas, Delta and recently British Airways), but Lufthansa seems to have found difficulty in achieving reasonable capital market transactions, averring on its Q1 results' call that the aircraft financing market was virtually dead.

With only a few months of liquidity remaining, time has been running out fast, and Lufthansa has had to go cap in hand to governments for help. Naturally, as the national flag carrier of Germany, it is far too big and important to the German economy to be allowed to fail merely because of a pandemic.

But it is also the owner of the national flag carriers of Switzerland, Austria and Belgium. And the very organisational structure has created a fraught background to negotiations with governments in the four countries in which the group owns airlines.

The second of the European major network carriers to the consolidation game, Lufthansa was able to learn from some of the mistakes of the Air France-KLM merger of 2004. But it didn’t quite have the imagination to go beyond making its acquisitions of Swiss (2005-8), Austrian (2009) and then SN Brussels (2009-17) anything more than direct subsidiaries of the German airline. This has possibly created difficulties around the negotiating tables in trying to get State help.

Switzerland came to the fore with a CHF1.5bn package of loan facilities (with an 85% stake-backed guarantee up to CHF1.25bn) but seems to have been done with a condition of being secured on the shares of Swiss and its leisure subsidiary Edelweiss. The funds will be ring-fenced, requiring all cash flow to be used primarily to repay the liquidity assistance, and banning dividends or remittance to the group parent until repaid. The Swiss general council said that it did not envisage taking direct ownership in the airlines, “as the success of Swiss and Edelweiss is essentially linked to their significant integration into Lufthansa Group”. (Interestingly, on the announcement the Swiss government stated that it would not provide support to easyJet — which has a Swiss AOC — on the grounds that its parent company had adequate resources).

Negotiations in Austria have taken longer. Lufthansa is reported to a have approached the government there for support of up to €800m for Austrian Airlines (AUA), but there appears to have been some reticence. The Austrian Chancellor Sebastian Kurz said “Lufthansa is and remains a German company, so there can be no state aid without something in return”. Austria has stumped up €300m in loans (with a 90% state guarantee and no doubt secured on AUA’s fleet) and €150m in grants, while Lufthansa will be adding €150m of its own cash. The deal includes a 10-year guarantee that Vienna Scwechat will grow in proportion to the group’s other hubs. “For us the priority was saving Austrian jobs and in particular securing Vienna as a hub,” said Kurz. “We have four strong hubs in a small space — we have Munich, we have Frankfurt, we have Zurich and we have Vienna. And since Lufthansa is a German company and the Zurich hub is extremely profitable, in Austria of course we are always slightly concerned about this Vienna hub.” At least Carsten Spohr successfully negotiated away the original idea that Austria would require an equity stake.

On top of this the Austrian government is requiring Austrian Airlines to halve its carbon emissions by 2030 (which it was probably going to achieve anyway), will introduce a €30 tax on flights of up to 350km (which will affect only 9 out of over 200 routes from Vienna pre-crisis, and maybe none post) and impose a minimum ticket price of €40, planning to stipulate in law that an airline ticket cannot be sold “below cost to the airline”.

Equally in Brussels Lufthansa is reported to have asked the Belgian government for support of up to €290m. But comments by Carsten Spohr at the AGM that Brussels Airlines would have to accelerate its “reboot” restructuring programme and could end up with an operation 25%-30% smaller do not seem to have gone down well. An article in the Brussels Times suggests that the Belgian Prime Minister Sophie Wilmès has made it clear she expects hard guarantees from Lufthansa on how the money, if any is forthcoming, will be used. Those include a commitment to invest in Brussels Airlines, to ring-fence the Belgian aid for the Belgian arm of the group, and to invest in the growth of Brussels Airport. Meanwhile there has been growing pressure from local environmental groups that Belgium should concentrate state aid on greener transport solutions, asserting that “air travel is often non-essential and reserved for a more affluent segment of the population”.

But it is on Berlin that the Lufthansa team has been concentrating efforts. The coalition government recognised that Lufthansa had little other choice (and was hampered in its negotiations by the departure of its CFO on health grounds), but the individual political parties seemed to have difficulties in working out what they themselves wanted out of a deal. Spohr tried to resist suggestions that the German State should take an equity position in Lufthansa, but his threats to put the group into liquidation didn’t quite work, and a €9bn bailout deal now appears to have been agreed.

Under the terms of the deal, the country’s Wirtschaftsstabilisierungsfonds (the Economic Stabilisation Fund, or WSF) will take a 20% stake in new equity for €300m (at the nominal price of €2.65 a share) in one fell swoop making it the group’s largest shareholder (see table).

It will also provide up to €5.7bn in stille Einlagen (or “silent contributions” — an idiosyncratically German debt and equity hybrid instrument) in two parts. The first, for €4.7bn (precisely €4,693,955,673.60), can be drawn in tranches at the company’s option up to the end of 2021. It is undated, can be terminated by the company in whole or in part on a quarterly basis, and carries a “profit participation” coupon of 4% for the first two years rising thereafter to 9.5% by 2027. It can be treated as equity and used to offset balance sheet deficits.

The second part, for €1bn, is to be treated as convertible debt and has a 6 year term at the same rate of interest as part I. It gives the WSF the right to an additional 5% equity stake (plus one share) in the case of a “takeover event” (which under German law could act as a blocking minority “golden share”); protection against dilution should Lufthansa issue equity without subscription rights; and “coupon protection” of 5% equity each in 2024 and 2026 should the accrued coupon on the silent contribution Part I not have been paid, subject to a maximum 30% total stake.

In addition Lufthansa will have access to a €3bn three-year credit facility organised by the state-owned KfW Bankengruppe.

The WSF undertakes to sell its shareholding in full at the market price by the end of 2023, as long as the stille Einlagen have been repaid in full and the sale price reflects a minimum 12% annual return.

It is hardly surprising that this bailout comes on the condition of two seats on Lufthansa’s Supervisory Board, restrictions on dividends, share buybacks and management remuneration. In addition, Lufthansa has to commit not to make any acquisitions; not to cross-subsidise group companies; and not to prepay existing debt obligations. As a sop to political tensions, it is required to “make a strong effort to use the funds... in connection with the green and digital transformation including the EU target of climate neutrality by 2025” (which it was planning to do anyway) while it will continue its fleet modernisation programme to invest in 80 new aircraft between 2021-23 (cleverly avoiding any political pressure to favour Airbus) and “expand its strategic alliances for aviation fuels based on renewable energies”. Other conditions include a ban on using the funds in tax havens and, somewhat surprisingly, for commercial advertising.

The agreement needed the approval of the Supervisory Board, an Extraordinary General Meeting of shareholders, and the EU Commission.

Objections sprouting from Brussels

Brussels had relaxed certain aspects of its regulations against state aid in the wake of the crisis — and had worked at break-neck speed (for it) since the middle of March in approving the plethora of applications by member states for the circumvention of the rules: responding within 24 hours and even at weekends. As the Economist pointed out in a recent article, “Never have the rules been loosened to the extent they have been today... politicians are brokering aid packages to industry in a way no one in living memory has been allowed to do”.

But Germany had gained approval for nearly 50% of the total €2tn state-aid approved so far, and was proposing to take a major equity stake in return for its support to Lufthansa.

The European Competition Commissioner, Margrethe Vestager emphasised that the EU would require penalties in order to allow the proposed state aid deal to go ahead because the provision of equity and the suggestion of the German state taking a major stake in the carrier would distort competition in a way that merely providing debt support would not. Rescue packages in which states injected large amounts of capital, she said, would be seen by investors as “a strengthening of the company”, and thus make it easier for saved businesses to raise money. (This incidentally raises the idea that the EU Commission will disallow Italy’s proposed renationalisation of Alitalia).

As remedies for perceived competitive distortion, the Commission required slot disposals at Frankfurt and Munich. These are Lufthansa’s two German intercontinental hubs and are only constrained airports because of Lufthansa’s dominating presence (Munich has some attraction for tourism, but Frankfurt has a relatively low level of point-to-point O&D demand). As the charts show, Lufthansa controls 70-75% of European departures and two thirds of all departures at these two airports, and the group has a similar dominance at its other three hubs. Initial suggestions for a disposal of up to 80 slots and around 10% of the portfolio were watered down to a paltry 12 slots (to be shared betwen three aircraft) at each airport. Only available to new entrants and by competitive tender — and importantly for operations to be based at the airports — the measure seems to be an empty face-saving gesture. Importantly it ignores the group structure and its dominant position within the tedescophone home markets where the Lufthansa Group has an 87% market share (see graph).

Brinkmanship

Negotiations done, a (virtual) EGM was called for the 25 June to gain shareholder approval. But shareholder approval for the deal was not necessarily a foregone conclusion.

Industrialist Heinz-Hermann Thiele (and Germany’s third richest individual) had built a 15.5% stake in Lufthansa’s since the beginning of March to become the group’s largest single shareholder, and had been critical of the need for the government to acquire any equity interest. According to the Frankfurter Allgemeine Zeitung (FAZ) he said “Lufthansa doesn’t need the state as a shareholder to restructure itself”, displaying a healthy distrust of political influence.

The threat that he may have voted against the proposal was enough for Lufthansa to pay staff wages for June a few days early while it still could.

In the end he voted in favour and the EGM granted the mandate for the capital issuance and the bailout deal. Looking ahead to Lufthansa’s post-bailout future, Theile told the FAZ that he “will continue to exert influence”.

Dire financial results

Lufthansa had delayed the full announcement of its first quarter earnings pending government negotiations: had these failed, it might well have had to file for bankruptcy protection. It is hardly surprising that the results do not make good reading. With the fleet mostly grounded for half the quarter, total traffic was down by 24% in RPK terms (and 26% in passenger numbers), revenues fell by 18% and operating losses reached €-1.22bn (a negative margin of 19%) from €-336m (-4%) in the prior year period. Net losses for the period came in at €-2.124bn. The group had to write off €925m for inefficient fuel hedges. Having decided on the premature retirement of 49 aircraft from its fleet of 744 (six A380s, five 747-400s and 11 A320s from Lufthansa; three 767s, 13 Dash-8s at Austrian; and 11 leased aircraft at Brussels Airlines) it applied a charge of €266m against realisable values. In addition it took a charge of €157m against goodwill at Eurowings and catering arm LSG.

The one bright point that the management could mention was an increase in margins in the logistics business: freight rates had been given a strong boost by the effective elimination of belly-hold capacity in passenger aircraft (which in normal times would provide half the total freight capacity).

In comparison with its European network carrier peers, Lufthansa produced the worst figures for the quarter (see chart). Air France-KLM reported results with revenues only down by 15% year-on-year, an operating loss of €-815m (15% of revenues), while a fuel hedge loss pushed it to a net loss of €-1.8bn for the quarter. IAG saw revenues decline by 13%, an operating loss of €-535m (13% of revenues and down from a profit of €135m in Q1 2019) while write-offs below the line resulted in a net loss of €-1.68bn.

But the comparison is irrelevant. All three of the large network carriers know that the financial news will get worse, and that their very existence relies on retention of sufficient liquidity to ride out the crisis. All three acknowledge that the airline industry is unlikely to return to the level of activity seen in 2019 until at least 2023, while the covid-coincident world-wide economic recession will particularly restrict a recovery in business and corporate travel on which they rely for the bulk of their business.

Never waste a good crisis

On the Q1 earnings call Carsten Spohr highlighted that Lufthansa was working on the basis that the group would have to be significantly smaller, but given the level of debt it was building (effectively raising 100% of what were its shareholders' funds), would need to use the crisis as a catalyst to transform itself into generating cash flow — and significantly higher levels of cash flow than it has been able to achieve in the past. In the last ten years the group has managed to average annual free cash flow generation of less than €1bn (see chart), and under pre-crisis plans wasn’t promising much more than that. But to be in a position to pay back the government bailout it will need to generate over €3bn a year in fairly short order.

Any return to operations will be slow. In the short run, the group aims to rebuild production from 3% of the original plan in May towards 40% in September. In the longer run Spohr said that he expected the fleet to be 300 units smaller than pre-crisis plans in 2021; and to operate 200 fewer aircraft than expected in 2022 and 100 fewer from 2023 (see chart).

The company has already permanently grounded 49 aircraft, and we should probably expect a significant number of the larger capacity and older equipment (A380s, A340s and 747-400s) to be mothballed prematurely.

But the group is still likely to continue its fleet reequipment, having committed to acquiring 80 new aircraft over the next few years (all now to be leased) as part of the agreement for the bailout — at the beginning of the crisis it had orders outstanding for 30 A350s, 20 787s and 125 A320s (see table).

It also needs a way permanently to reduce overheads and variable costs. This will mean redundancies; and the group will be hoping that it will finally be able to achieve long lasting adjustments to its legacy employment contracts, effectively hiding behind the pandemic crisis to affect change. Lufthansa had been busy trying to negotiate with its main unions to be able to present an agreement in principle by the time of the EGM. Publicly the group has stated that it will need to get rid of 22,000 full-time positions group wide (out of a total group complement of 140,000) and half of these in Germany. Lufthansa German Airlines will suffer the brunt of the cuts, but Eurowings — now envisaged to come out of the crisis with only 90 aircraft (down from 120) — and the operations at Austrian and Brussels, which had been financially challenged even in the good times, will also be targeted.

Will these measures be enough? It is likely that the group will need to sell some of the family jewels.

Lufthansa had already planned to dispose of the European arm of its catering operation LSG SkyChefs to Gategroup (a deal finally approved by the European competition authorities at the beginning of April) having admitted that it no longer sees catering as a core activity. It is likely to start hunting for possible buyers for the remainder of the operation.

Through Lufthansa Technik the group operates the world’s largest independent MRO business. Although a third of the €6.9bn revenue comes from intra group sales, it prides itself on a customer base of over 850 airlines, lessors, OEMs and operators of private jets worldwide. It has tended to regard the MRO business as a core activity but may (perhaps grudgingly) consider a minority sale or IPO.

Similarly its Logistics operations, with revenues of €2.5bn, make it one of the largest European freight operators, and one of the few, through Lufthansa Cargo, to continue to operate a meaningful fleet of freighter aircraft.

Unlikely as it may appear, there may even be someone at some point in the future willing to acquire Brussels Airlines (which never fitted comfortably in the portfolio) — or the group could let it slip into liquidation — although Lufthansa would baulk at the idea of dismantling the tedescophone hegemonic grouping with Austrian and Swiss. Finally it also has a bundle of unencumbered aircraft.

However, these are all aviation assets, and prices at anything more than firesale valuations are difficult to foresee for some time to come.

Carsten Spohr holds on to the idea that it is right to pursue a policy to treat all stakeholders equally to provide the basis for a sustainable future. But with government stakeholders on board, superseding customer, employee and shareholder, Lufthansa will be a considerably changed animal when it emerges from this existential crisis.