European majors:
Degrees of rationality November 2016

In the depths of the downturn following the global financial crisis, each of the three top network carrier groups in Europe promoted strategies to return to a sustainable level of profitability by 2015. Things don’t always go as planned; and it is only IAG that has come anywhere close, generating a return on invested capital of over 13% and operating margins of 11%. Lufthansa and Air France-KLM have stopped talking about any targets for creating returns to shareholders.

All three have recently published their third quarter and nine month’s results (with IAG capping their’s with the group’s annual investor day), which each show broadly similar trends. Yields and unit revenues have been under pressure — as to be expected, when fuel prices fall, airlines pass on part or all of the savings to the passenger. There does however appear to have been market weakness on the Atlantic and to Asia which has added to pricing pressure.

For the three months to September — the main summer season — each registered a decline in revenues, fall in operating profits and a boost to net income. To be fair, the underlying performance at IAG was somewhat better but marred by losses on translation of British Airway’s results into Euros following the collapse in Sterling after the UK’s referendum result.

The mainline network airlines in each group maintained “capacity discipline”; although in IAG’s case Iberia, having gone through successful restructuring in the last few years has resumed growth with capacity up by over 5% in the nine months. BA increased capacity by 3% and Aer Lingus (acquired in August last year) expanded strongly on the Atlantic, growing by 9%.

The three groups have all been pushing growth into their respective “low cost” brands. Lufthansa’s Eurowings increased capacity by 25% year on year in the nine months and for the period accounted for 9% of the group’s total capacity (in ASK terms) and 17% of passenger numbers. Air France-KLM’s Transavia grew by 13% and now accounts for 15% of the group’s total passenger numbers and 9% of capacity. Vueling — the only one of the three an independent player — had operational difficulties but still grew by 11%. It now accounts for 22% of IAG’s passenger numbers and 11% of seat capacity.

In these earnings presentations sometimes what is interesting is what is omitted. In this season’s results IAG, for the first time since the merger between BA and Iberia, neglected to detail the respective revenues and operating profits by “brand”. There was also a notable absence of reference by any of the three to the Atlantic metal neutral joint ventures. We can only assume that there is some embarrassment associated with this collective omission.

Air France-KLM

Air France-KLM meanwhile took the opportunity to announce a new strategic programme. Having failed in its “Transform 2020” and “Perform 2020” plans to persuade employees that it really needed to transform and perform, and following a change of senior management, new CEO Jean-Marc Janaillac has introduced a new plan entitled “Trust Together”. On the face of it, it appears to be an internal message to try and mend badly-eroded relations between the Air France management and the French unions, as well as between Air France and KLM.

Alongside this the group announced plans for what was described as a new long haul low cost airline based at CDG: up to ten aircraft by 2020 with volunteer crew from the Air France corpus. It would in fact be a full service airline probably operating the full Air France brand, so could not possibly be described as low cost, and smacks to us as an attempt to introduce ‘B’ scale wages in the company’s primary hub to force through employee productivity. This is sort of what British Airways managed to do at its London Gatwick operations a decade ago: the difference being that Gatwick is not BA's main hub, with flights on predominantly point-to-point low-yield "leisure" routes.

The company states that this venture will allow it to fly long- and medium-haul routes that are currently uneconomic or subject to intense competition and give junior pilots the chance to fly long-haul. Even if the unions do agree to the idea, it is not clear what would happen at the ten aircraft limit. It does nothing to create significant productivity improvements in the Air France mainline operations — or indeed change how they manage pilot seniority lists. The plan seems doomed to fail.

At the same time Air France has decided to rein back on expanding Transavia into a pan-European brand (which idea, for some reason, the French pilots never liked), and plans to revert the low cost subsidiary to a defensive position in Amsterdam and France. Transavia France, however, by pilot agreement, is limited in the number of aircraft it can operate. No doubt the attempt to force its way into Lufthansa's second base in Munich has been an unmitigated disaster (although the LCC subsidiary did improve operating results in the third quarter by around 20% to €100m, giving it €17m for the nine month period up by an underlying €38m from the prior year levels). Meanwhile, it will once again rebrand the French domestic point-to-point services (no doubt still heavily loss-making) from a mixture of Air France and HOP! to HOP! Air France.

Lufthansa Group

Lufthansa's move to develop Eurowings as a low- cost point-to-point alternative to the mainline network operations and catapult it into the position of the third largest pan-European LCC has been given a boost by the possible wet-lease deal from the moribund Air Berlin (see Aviation Strategy, October 2016). It describes the Eurowings business model as being "sustainably successful through [a] unique market position".

It aims to be the largest point-to-point European operator in its home markets (Germany, Austria, Switzerland and Belgium) and hold the top or second position in all relevant German airports. It currently operates around 90 aircraft in seven bases (Hamburg, Berlin, Hanover, Düsseldorf, Köln/Bonn, Stuttgart and Vienna). And following the Air Berlin and SN Brussels deals it expects to operate 160 aircraft in eleven bases — with the addition of Brussels, Munich, Salzburg, Palma di Majorca and Brussels. (For some strange reason it plans to include SN Brussels — it will take full control early next year — within the Eurowings umbrella).

While keeping growth at the group's network carriers below market rates (for the nine month period capacity in ASK terms at Lufthansa, SWISS and Austrian grew by 2.5% year on year, while passenger demand in RPK terms was on a par with prior year levels), Eurowings has been expanding strongly — and particularly on long haul — with ASKs and RPKs up by 25% in the nine months (but passenger numbers up by only 8% and revenues by 7%). Revenues for the point-to-point carrier for the period approached €1.6bn, not far short of that achieved by Austrian, but it registered an adjusted operating loss of €35m apparently down nearly €100m on the same period last year.

Lufthansa avers that it will get Eurowings' operating unit costs down to 5.8€¢ by 2020 from 8.0¢ last year. This is still a long way above the figures for European market leader Ryanair (which has just launched a broadside at Lufthansa by starting operations at the Frankfurt home base while pushing expansion into the German market). Meanwhile industrial relations continue to ebb: strikes at Lufthansa and Germanwings by the pilots, and by the cabin attendants at Eurowings.

IAG

IAG was particularly hit in the quarter by the fall in the value of Sterling against the Euro. The operating margins at British Airways were on a par with the prior year third quarter at 18.6% but the collapse in the pound resulted in a net €140m lower operating profit on translation. The effects of exchange rate movements at British Airways overall is somewhat complicated: around 40% of revenues are each in Sterling and US Dollars, with only 10% in Euros.

Given its strength at its base at Heathrow — which is still the premier long haul gateway to Europe — it has the ability to sell into higher value currency markets and "switch on" transfer traffic through its hub, away from UK originating sales (which might be expected to weaken in light of lower growth and lower value of the pound).

The highlight was the performance at Aer Lingus, achieving an operating margin for the quarter of nearly 30%, up nearly seven points on the prior year level. It even achieved a near 21% return on invested capital. Aer Lingus has been expanding strongly, particularly on the Atlantic. Here the group has an opportunity to develop Dublin as a new "low cost" gateway, with a distinct advantage of having US immigration preclearance facilities. In one sense it provides the extra runway capacity lacking at Heathrow. The challenge will now be to bring Aer Lingus into the immunised joint venture with American on the Atlantic. 

At the group's Capital Markets day, the management contended that nothing had really changed since last year (see Aviation Strategy, November 2015). The group has slightly reduced its long term growth plans by 1 point to 3%, cut capital expenditure to an average €1.7bn over the next four years, and reduced its target of average EBITDAR to €5.3bn from €5.6bn. It maintains its plans to target 15% ROIC, operating margins of 12%-15% and earnings growth of over 12% a year.