Lufthansa's bmi buyout: what does it add? November 2008

At the Lufthansa Q3 results meeting the management appeared to mention as an aside (and as if it were no surprise) that Michael Bishop had exercised his put option to them for his majority shareholding in British Midland — the second largest operator at London’s Heathrow — only a few months before they would have had to decide whether to exercise their own call option. The exercise price of €400m, albeit slightly less than the value of the company’s Heathrow slots that bmi capitalised this year for the first time, at least gives Sir Michael a reasonable pension fund. It is also recompense for his developing a serious competitor to British Airways at its own hub. It also creates a benchmark for SAS’s remaining 20% stake in bmi — and SAS has indicated its wish to divest for some time. However, as bmi is a private company, there should be no legal pressure for Lufthansa to have to make a bid for the rest of the company (even though the management stated they were in discussions with the UK Takeover Panel on the subject) and with a firm majority stake they may see no absolute need to spend more of their valuable cash than need be. The management admitted that they like Heathrow — "we make money on those routes" — but must be in a bit of a dither as to what to do with the legacy they have acquired. Depending on regulatory approval (Michael O'Leary may complain, but Brussels is unlikely to) the deal should be finalised by January 2009.

What it does provide is an extra 11% of the scarce Heathrow slots. They should be able to add that to their existing 4% slot holding, and SAS’s 3% and United’s 2% (both partners) to generate a brand position for the Star alliance at Europe’s prime transatlantic gateway similar to that enjoyed by American at United’s stronghold in Chicago, and may undermine British Airways' hub at the constrained airport.

The difference is , however, that this is a numerical agglomeration of slots rather than an integrated hub/spoke system. They are probably considering trying to bring on board the virtually nonaligned Virgin Atlantic (with its 3.5% share of the slots) — reputed to have had various discussions for co–operation with British Midland in the past — which will be facing significantly increased competitive pressures once the BA/AA/IB ATI and joint venture are given the green light next year. With hope seemingly receding that there will be a third runway at LHR — at least within a reasonable time frame — this would also help to make sure that Lufthansa’s long–time trans- Maginot line rivals at Air France are kept out of the prize airport in Europe in any serious way; although more capacity would become available when dual usage is finally allowed (which will have to happen with or without a third runway), developing a similar 20% share of the slots will be exceedingly difficult.

In any case the Star alliance is due to move to single terminal operations in Heathrow — albeit an area due for substantial construction upheaval as BAA develops Heathrow East out of the ashes of Terminals 1 and 2 over the next five years in time to miss the London Olympics (while SkyTeam will be moving into the almost inaccessible Terminal 4). They will also acquire a questionable regional business, a loss–making European operation (and having covered many of those losses in the ECA in recent years they should be well aware of the problems). It also gives them a low cost wannabe in bmibaby, which may make little sense in the Lufthansa portfolio. Having said all that, there should be substantial upside from full integration of British Midland within the Lufthansa portfolio of hubs and networks — its own Frankfurt and Munich, Swiss’s Zurich, SN Brussel’s Zaventem and — who knows — maybe Vienna or Milan. This time, however, the management may have its work cut out to develop a real restructuring programme for bmi to avoid damaging losses in this cyclical downturn.

Curate’s egg of results

Also intriguing is (almost a footnote to the quarterly accounts) the announcement that Lufthansa will buy out the majority 50.9% of Eurowings — which runs the (slightly) lower cost regional output and the low fares operator germanwings — with effect from the end of December. This signals a complete breakdown in the hoped–for deal to merge Eurowings/germanwings with TUIFly, designed to provide some rational consolidation of the domestic German market. Lufthansa also has the option to pass this stake onto someone else — if the airline can find another buyer in the current environment. Meanwhile, the results the company announced at the same time were a bit of a curate’s egg. The headline figures were not that bad all things considered, but for cultural reasons Lufthansa does insist on publishing cumulative numbers through the year, hiding as best it can the individual quarterly performance. Nevertheless, for the three months to end September group revenues were up by just under 4% year–on–year and 14% for the nine months (this quarter is the first to show a relatively real like–for–like comparison, SWISS having been fully consolidated from July 2007). Operating profits reflecting the extraordinary increase in fuel costs in the period fell by 62% (if you include all the usual “unusual” items) to €222m, or by 52% (if you don't) to €279m. The total fuel bill jumped by 48% to €1.65bn in the period (and would have climbed by 78% to nearly €2bn were it not for the Euro strength and the hedging programme). The principal decline was felt in the passenger division where operating profits fell by 76% to €112m following a 7% increase in capacity, a 5% growth in demand and a slight decline in unit revenues (mostly because of Euro strength). This was partly impacted by the strikes it suffered in the quarter (which probably cost it some €100m in foregone profitability) and the knock–on effects for the network from maintenance disruption.

The Logistics division (aka Cargo) did somewhat better — it has been somewhat easier to get fuel surcharges to stick — with a 10% growth in revenues and a 28% jump in operating profits to €46m for the quarter. Maintenance also didn’t do that badly given the strength of the Euro in the period with a modest 1.5% decline in revenues and only a 5% fall in operating profits to €69m. The catering operations also saw an earnings decline in the period — again not helped by the Euro strength and also the increase in food and commodity prices — while the IT Services division actually saw profits more than double from an almost insignificant €11m, mainly because of the absence of a prior year impairment charge. For the nine months, helped by the consolidation of the first half, operating profits fell by only 9% to a little short of €1bn on revenues up by 14% to €18.5bn.

Given the current economic environment all these numbers may be somewhat irrelevant. Having been a little reticent earlier in the year, the group has finally decided that it is unrealistic to expect that it would be able to reach its target of matching last year’s record profits. It has at last adjusted its capacity plans: it is now looking for a modest cut in winter 2008/09 capacity (down from an earlier plan for a 2.5% growth) and planning virtually flat 1% growth in capacity for 2009 (except for Air Dolomiti’s establishing a handful of aircraft at Malpensa). These cuts may not go far enough, and although it is always difficult for an airline to shrink, LH may find it necessary to trim next year’s capacity further. However, like Air France, it does have a well balanced portfolio of routes and should be able to switch capacity to those areas that still display some strength. Moreover, it has over the past few years put in place a substantially higher level of operational flexibility than it has ever had — with almost unique union contracts negotiated, with the anticipation of the risks of a downturn, to include the possibility of furloughs and short–term working.

The group, however — at least for the moment — will not be changing its capital spending plans. It has 53 aircraft due for delivery next year (including the first two of the long–awaited A380s, and it would hardly be politically acceptable to cancel those, would it?) — but the management did state that it will use these now purely for replacement and effectively accelerate the disposal of older, less fuel–efficient tin cans.

As with its great rival Air France, Lufthansa’s balance sheet appears strong. At the end of September it had some €3.3bn in cash in hand against debt of €3.4bn, pension provisions of €2.3bn and equity of €7bn (if you are willing to credit intangibles of €1bn). This cash balance is well into the management’s comfort zone of wishing to maintain a minimum liquidity of €2bn in ready money — and supplemented by credit lines (with some 50 separate banks) of a further €2bn.

At the results presentation it was a little surprising to find that the erstwhile strong fuel hedging position had unwound a little — all because of the collapse of Lehman Brothers — although LH could credit the P&L with some €70m from the default of its counter–party. It appears from the material presented that the failed New York investment bank had been the other side of the hedge for 8% of the Lufthansa group fuel uplift requirements for 2008 and 2009. As a result the group is only 72% hedged for the rest of the year (which in one sense may be a blessing in disguise) and 57% for 2009 — well below its normal corporate targets. As a result it looks as if Lufthansa’s effective fuel hedge collar has widened significantly to $55-$103/bbl equivalent (between which the group gains no benefit against spot prices, below or above which it suffers or benefits respectively). At current contango forward rates it looks as if the group’s fuel bill (excluding bmi, or any other new acquisition) would increase by a further 5% next year to some €5.6bn (up from €3.4bn in 2006).

This downturn presents difficulties for many but opportunities for the few to accelerate consolidation among the legacy network carriers in Europe. The British Airways/Iberia merger will no doubt eventually go ahead; Lufthansa, BA and Air France are all skirting around the new improved Alitalia — which through the effective merger with AirOne provides some consolidation of the Italian market; Lufthansa appears the only contender for long–time partner Austrian (and its symbolic €1 bid for the government’s shares, less the debt, may even be accepted); Lufthansa has recently taken a 45% in Brussels Airlines, with an option for the remainder, giving it some greater access particularly into francophone markets; and now it finally gets bmi giving it a base at Heathrow. With luck the group should be able to manage all this without getting indigestion.