Damage limitation September 2009

In this recession “premium” business has been particularly badly hit – and it is not just the bankers who have stopped flying in flat–beds on the Atlantic; all businesses, faced with financial uncertainty, have reassessed their travel needs. According to IATA, passenger demand in F- and J/C–classes fell off a cliff last October and the rate of decline accelerated subsequently to hit a year–on–year fall of 25% by May this year. The severest declines were experienced in intra- European and intra–Asian route sectors, each down by 35% against prior year levels; more significant for the network carriers was the 18% decline in premium traffic on the Atlantic and the 9% fall on Europe–Far–East, the two main premium revenue generating segments (note that IATA trends refer to pax numbers; premium revenue will have fallen even more precipitously). At least, however, there are the first signs that the slump may be bottoming, with modest reductions in the rate of decline on the North Atlantic since Easter.

A consequence of plummeting demand – and particularly falling business demand – is a collapse in pricing and yields in all classes of travel, exacerbated by the removal or reduction of the fuel surcharges imposed over the past few years. In each recession fears are expressed that premium travel will never recover to previous levels, and that those businesses who allow personnel to fly in the back of the bus when necessary will never again allow them to be pampered in the front. However, when the good times return, and an air ticket just has to be bought, such cost disciplines tend to disappear.

In the meantime, this resulting lack of income as yields and traffic slump (and IATA is currently forecasting a massive 15% drop in world airline revenues this year) is proving painful for Europe’s network carriers. For them this is arguably the first real economic recession in the deregulated era, and the one that could well further accelerate consolidation and polarisation in the industry. Much has changed since the last economic downturn of 1989–1992 (when Air France had to be bailed out by its government), and the top three carriers in Europe have all developed elements of flexibility in their models to enable them to react swiftly to changes in the market.

In the lead up to this downturn BA, Air France/KLM and Lufthansa had all been able to restore balance sheets (BA’s pension problem notwithstanding) and cash balances to reasonable levels – and as usual at any time in this industry, cash is king. The results from the top three carriers for the quarter to the end of June show very similar performances from all three, after allowing for the effect of sterling’s weakness on BA’s results. Total revenues fell by some 20%; passenger unit revenues were down by between 15%-20% and cargo unit revenues down by around 30%. Both BA and Lufthansa appeared to have achieved a slightly better unit cost performance — and Lufthansa particularly managed to reduce its cargo unit costs by over 12% — while Air France/KLM may have had some impact from the fatal loss of the A340 on the South Atlantic. EBITDAR for BA and Lufthansa halved from the prior year levels and margins fell by five points to 6% and 9% respectively. At Air France/KLM, the EBITDAR margin fell to an uncomfortable 2%.

Interestingly only Air France/KLM experienced a material operational cash outflow in the quarter; Lufthansa even managed a relatively healthy cash inflow. All three have been able to tap the markets for cash. AF/KLM issued a €660m convertible in June, while after the end of the quarter BA raised £350m in a similar issue and Lufthansa some €750m from a straight bond issuance. After allowing for these, all three carriers are now sitting with a relatively healthy cushion of cash reflecting 20% of annual turnover.

The focus for all three is damage limitation (only at BA is the word “survival” mentioned). This means: cut capacity to match demand; cut costs (particularly labour costs) to reduce losses and capex to limit cash outflow; adjust capacity and product to the weak market; and yet be in a position to benefit from the upturn when it comes. They each have a reasonable proportion of their fleets on operating leases, allowing some flexibility in medium–term capacity management, while Lufthansa has the apparent additional advantage of relatively short depreciation policies giving a higher proportion of fully depreciated equipment on its balance sheet. Each are deferring aircraft deliveries and maintaining a flexible approach to capacity as much as possible. The suspension of the 80/20 slot usage rule – at least for this summer season – helps both Lufthansa and BA (although it is unlikely to be extended for this winter season too).

On the cost side, Lufthansa had been particularly successful since 2001 in renegotiating union contracts to provide significant flexibility in working practices and allow furloughs and short–term working. BA, although helped in some way by the changes it could introduce last year from the move to Terminal 5 at Heathrow, is determined to gain long–term productivity concessions. KLM has generally tended to have pragmatic relations with its unions and, whereas Air France may have a little more difficulty under the French social environment, it has at least recently proposed a voluntary redundancy programme to fit the workforce to a planned 5% cut in passenger capacity and 15% cut in freight capacity.

Air France/KLM may still have some benefits to accrue from the 2004 merger of the two carriers, but it will be difficult meaningfully to increase the synergy savings from those already in its plans. The joint venture on the Atlantic with Delta in contrast – which started in full in April this year – should be accretive even in these difficult times. Lufthansa is benefiting strongly this year from its more recent acquisition of swiss – though it may find it harder to digest bmi, Austrian and SN Brussels, plus develop its new base in Malpensa. At the same time it has started code–share operations with its minority–owned Jet Blue partner through JFK, to try to improve feed through New York where the Star alliance is relatively weak. As for BA, if the joint venture ATI application with American and Iberia finally gets approval, and assuming that the marriage with Iberia finally gets consummated, BA’s competitive positioning should gain a significant boost to put it on a par with the other two majors. Meanwhile, BA continues to suffer the most excessive pressure from LCC competition (although in the short–term possibly helped as they move their attention away from the saturated UK market and focus on continental Europe).