Lufthansa: Germanwings - reinventing short haul October 2013

In October Lufthansa held another in its series of presentations for investors on the progress of the “Score” programme — the restructuring plan it has in place to restore profitability to reasonable levels (targeting €2.3bn operating profit) by 2015. This time the group put forward the CEO of the airline division (Lufthansa Passenger Airlines) Carsten Spohr (and a possible contender to replace the current group CEO), along with the CEO, Thomas Winkelman, and CFO, Axel Schmidt, of Germanwings: the group’s new saviour for short haul operations.

The concentration was on the plans to transform the Lufthansa short haul operations and made no mention of the other group subsidiaries of SWISS, Austrian or associate Brussels Airlines. Spohr started off by emphasising that Lufthansa Passenger Airlines and Germanwings combined is effectively the largest single European airline with €17.3bn in revenues, 75 million passengers and a fleet of over 400 aircraft. It is also the largest single unit in the Lufthansa Group, accounting for 75% of total passenger revenues and 60% of total group revenues.

Lufthansa is the most exposed of the European three major network carriers to the intra-Europe market — 45% of revenues coming from short haul operations, 27% of revenues from operations to the Americas (with limited operations to South America), 19% to the Asia/Pacific region and a modest 9% into the Middle East and Africa. It also prides itself on having very strong premium revenue and corporate exposure — with 35% of passenger revenues coming from premium traffic and around 40% of revenues generated from corporate contracts.

Recent performance was said to be encouraging. In the first half of the year capacity was basically flat (despite a reduction of 5% in the number of flights) and a modest 1% increase in RPK demand pushed up load factors by 0.9 percentage points. Unit revenues improved modestly but, importantly, unit costs fell by 1.5% (or 1% excluding fuel) — an unusual achievement in the absence of capacity growth. The first half 2013 operating result improved by 66% to a mere €-91m.

Spohr restated his view that the current trends indicate that the group is on target to achieve its business plan target for 2015. He suggested that the Germanwings development would reduce short haul losses of €200m in 2012 by around €90m in the current year and maybe produce a profit by 2015. He also highlighted that the group had concluded agreements with the ground and cabin crew leading to a near 5% improvement in cabin productivity so far this year, and announced a “process optimisation” programme (something that British Airways initiated over ten years ago) to be launched shortly with the aim of additional savings of €180m a year.

Meanwhile, the company announced a massive order for fleet replacement and re-equipment over the next twelve years. Spohr only mentioned the impact on Lufthansa — whereas the fleet order effectively includes aircraft for the other group carriers. For LH, the group ordered 25 A350s to replace its fuel-hungry A340-300s from 2016, and 34 777-9Xs to replace ageing 747-400s from 2020.

In the medium term the company is planning capacity growth at half the market rate “in selected markets”, with a base case of ASK growth of 3% pa. The fleet order however gives it the flexibility to adjust capacity expansion depending on decisions on and timings of aircraft retirements.

Recent regional developments.

Spohr highlighted the regional differences in trading and profitability. On short haul European routes (including domestic) the company was on track to generate the first positive return in more than five years, helped by the transition of non-hub operations to Germanwings. Retrenchment at airBerlin had helped in creating what he called capacity discipline, and improvements in yields were being achieved partly because of the slow-down in capacity expansion by LCCs (European yields in the first half grew by 1.2% year on year against a 3% decline in capacity).

On the Atlantic he averred that the results were very positive. Now that the North Atlantic market has consolidated among three joint venture groups, capacity growth (if any) remains muted with the result that yields have been performing well. However, at the time of the first half results the group announced that its total capacity on the Atlantic grew by 6% and yields by 2%. This capacity growth is hardly muted in itself and may have been influenced by changes in aircraft configuration and reduction in premium cabin space. From the joint venture perspective the actual capacity growth may well be lower than that published by Lufthansa.

The Asian and Middle East/Africa routes in contrast have been under pressure — yields on the Asian routes fell by 7% in the first half of this year (and by nearly 10% in the second quarter) largely driven by currency movements (and a significant hit from the weakness in the Yen). However, the group has some protection on the important Japanese routes through its joint venture with All Nippon. The group is evaluating partnership options in the strongly growing Chinese market. Spohr obviously feels that Air France-KLM has stolen a march on them with its links with China Eastern and China Southern. Tersely he noted that competition from the Middle East super-connectors remains intense (and made no reference to Etihad’s ambitions with airBerlin).

SCORE Agenda

Lufthansa’s SCORE programme as it applies to the airline revolves around cutting out complexity to reduce unit costs, while at the same time investing in the “best” product and most efficient fleet. Spohr has made it clear that he wants Lufthansa to be Europe’s first Skytrax 5-star airline within the next two years.

• Capacity & fleet size : Lufthansa is freezing its fleet size at 400 aircraft until 2016 (some 80 units fewer than it had planned even in 2010). It is aiming to grow at half the market rate over this time with planned capacity increases of around 3% a year, almost all this growth will coming from squeezing more seats onto aircraft. However, in the short run it looks as if total ASK capacity will actually grow by 4%-5% year on year in 2014 and 2015 as the fleet reconfiguration takes place.
• Restructure Long haul: It is reconfiguring and restructuring the long haul fleet, taking First Class out of a third of the aircraft, and reducing premium class space in the rest, to make room for an enhanced premium economy, with the aim of “optimising” revenue per flight to cost per flight. The new technology aircraft won’t enter the fleet until 2016. It will phase out the 747-400 and A340s, replacing them with the 777-9X and A350-900.
• Restructure Short haul: It is significantly simplifying the fleet structure from nine aircraft types to three — and is phasing out all aircraft below 70 seat capacity. It has already got rid of all the turboprops and will be phasing out the CR7s by 2015. It still has some 737 Classics which should also go by 2015 to leave an all-A320 main line short haul fleet (with A320NEOs coming in from 2016). It will retain its E90/95s and CR9s as hub feeder regional aircraft and on some selected non-hub operations. The new Germanwings operations (see below) are designed to bring the non-hub flying to break-even.
• Reduce unit costs: the CEO’s new project “Shape” is designed to try to turn Lufthansa from a function-oriented to a process-oriented business, in order to reduce unit costs by the use of shared services. Moving to a process orientation should enable the airline to cut out excess duplication of overhead resources — one of the historical burdens of the legacy carrier. When BA made this move some years ago it removed several layers of management without impacting front-line services. It also aims to restructure all outstation operations and reduce costs from all suppliers (including ATC and internal group suppliers). The Shape programme is targeting a reduction in staff costs of some €180m a year.
• Invest in revenue quality and best product: It will be rolling out new F-class and J-class products bringing them up to date with the industry norm full flat-bed long haul seats and which will allow it to introduce a new Premium economy seat.

The new Germanwings

Few network carriers have managed to establish a low cost subsidiary and made it work. In fact Lufthansa’s Germanwings brand, which has competed head-on with Lufthansa itself, can hardly have been described as that successful; but at least it has been losing less money than Lufthansa’s own short haul network.

Lufthansa’s problem is unusual for a network carrier: a substantial portion of its short-medium haul operations bypass its main hubs at Frankfurt and Munich. Underlying this is the geopolitical nature of the German market: it is decentralised, based on the Federal organisation of the country; there are substantial domestic traffic flows between the Länder main cities; there are substantial business oriented flows from the major cities to other centres in Europe which attract good point-to-point services; Lufthansa’s main base at Frankfurt is not itself a very strong O&D market. From Lufthansa’s position it needs to be able to offer its major corporate customer base the shorter haul direct routes in order to retain the corporate deals for the more lucrative services longer haul.

Lufthansa itself is the second largest carrier in Europe in terms of short haul seats offered (behind Ryanair and ahead of easyJet) with around 9% of the market in 2012. Combined with Germanwings operations some 25% of its short haul seats (under 3,500km) do not touch its hubs in Frankfurt or Munich.

The map on the left shows the major traffic flows within Germany (the thickness of the lines relate to the total number of seats on offer in the market). The routes with the highest density of capacity are naturally those to and from Munich and Frankfurt. However, there are still some very strong flows between the other major centres in Berlin, Hamburg, Düsseldorf, Köln, Stuttgart and Hannover.

Lufthansa’s answer to the problem is to turn all the non-hub flying to a new Germanwings. It is injecting all its existing intra-European routes that bypass its hubs into the “new” carrier. This will affect some 10% of Lufthansa Passenger Airline’s revenues, 20% of the passenger numbers and a third of the short haul fleet.

The management refer to it as creating the largest German “low cost” airline with €2bn of revenues, 18m passengers a year and a fleet of 90 aircraft; although it would in fact be around half the size of airBerlin. Operating from both primary and secondary airports it will account for 27% of the company’s domestic capacity, while bringing Germanwings fully within the Lufthansa operation (including yield management systems) will add the strength of the Group’s strong corporate contract base and FFP (and remove an internal competitor).

After a six month delay, Germanwings introduced its new design, “philosophy and product” at the beginning of July. Perhaps accepting that no German airline could really be low cost, the mantra is “Choice at Low Cost” providing, in the management’s view, a unique offering in Europe. In one sense the company is applying the LCC philosophy (quick turnaround, high utilisation, no overnight hotacc expenses) with almost a “re-bundling” of the LCC product to come closer to matching the legacy short haul product.

To this end it is offering a quasi business class (front three rows of the aircraft only), higher seat pitch of 31 inches in the first ten rows (against 29 inches in the rest of the bus), simple pricing points that progressively re-bundle the elements of flight service (food, baggage) but are limited by type of distribution channel. The new operation will probably have to incorporate some of the legacy Lufthansa distribution channels to satisfy the needs of all customers — but the management states that the customer will pay all additional transaction costs and there will be no incentives given to intermediaries.

It will focus on the top six markets in Germany outside Munich and Frankfurt, and reposition the “brand” to try to give a clear differentiation in the market place. By introducing the mix and match product approach (“focus on individualisation to meet customers’ needs”) it hopes to retain the existing Germanwings and Lufthansa passenger base. Above all the strategy will be to maintain Germanwings’ lower unit cost base and gain significant uplift in overall yields.

The aircraft fleet is being restructured. The aim is to reach 2015 with a fleet of 64 A319/A320s and 23 CR9s leased in from Eurowings. Ideally there should be a single aircraft type, but to retain market presence, Germanwings was willing to use the regional jets.

In the transfer of operations to Germanwings the group maintains it will achieve significant unit cost savings on the old Lufthansa operation (despite the increase in complexity). Much of this comes from the changes in the fleet, removal of the ancient 737s, increase in average seat capacity, and the ability to procure passenger handling at market costs. A significant benefit comes from crewing costs: the company will be putting all the cockpit crew and cabin crew on the Germanwings pay-scales leading to a 15% reduction in pilot costs and 30% in cabin crew costs per block hour.

The company stated that the results of the changes so far have been encouraging. It presented a forecast for 2013 showing traffic demand up by 5% against a 1% rise in capacity and an overall improvement in revenue per passenger of 4.5% (a modest increase of 1.6% on the Lufthansa services and up by 11% on the Germanwings services), and expecting a near €90m improvement in earnings in the current year.

The new Germanwings operation is designed to be one of the largest contributors to the SCORE programme with the aim to return the non-hub network to break-even in 2015 effectively targeting a €200m turnaround in fortunes.

Profit warning?

Only three weeks after the investor presentation the company came out with what was viewed as a profit warning. The group undershot market consensus forecasts for the nine months to the end of September, stating that its adjusted operating results came in at €660m. Last year for the same period the group published an operating result for the first nine months of €628m. In view of this the group has refined its forecasts for the full year pointing to an operating result of €600-700m after “non-recurring” effects of around €300m, compared with a published figure for 2012 as a whole of €524m. The group maintained that current trading was not that much different from its earlier expectations and that it retained its goal of achieving €2.3bn in operating results by 2015.

However, the announcement was far more complex than this, and introduced the idea that we should be looking at profit performance measures including and/or excluding various one-off restructuring costs, as if restructuring costs were unusual or extraordinary. This seemed designed to confuse; as one London-based analysts put it, “a flag carrier that is not restructuring is not an airline but an aeroplane museum”. Another element of confusion in communication comes from the statement that capacity would be growing at an average of 3% a year — below market trends. However, from the company’s own plans it appears that it is expecting capacity growth of over 5% in 2014 — albeit partly an automatic reflection of the changes in the fleet and seat configurations. Achieving the stated €2.3bn target annual operating result in the next 26 months may be achievable; but only there is a remarkably strong performance in 2015.