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European airline consolidation to enhance financials? Few deals to be done, at least locally

15th May, 2013

European airline margins have underperformed other regions for years. There are many reasons for this, but our analysis suggests that Europe’s relative lack of consolidation may be a significant one, since margins appear to be correlated with market concentration. Even after a number of significant deals over the past decade, the European market is less concentrated than North America, where consolidation has gone further, to the benefit of margins. Europe is also less concentrated than Asia-Pacific (analysed as its sub-regions), whose margins have consistently been the highest.

If consolidation brings structural benefits, are there still European deals that can make a difference? Europe has a long tail of small carriers, which are unlikely to have a significant impact, but comparison with North America points to the potential for further combinations among the top five. Nevertheless, there are hurdles to such deals, not least of which are the ongoing restructuring programmes at Europe’s Big Three and the incompatibility of LCC/FSC mergers, but some second tier groups could be targets.

European airline margins have under-performed for years

The profitability of European airlines has consistently under-performed other regions in recent years, measured by operating margins. IATA figures show that the average margin for Europe from 2009 to 2012 was just 0.3%, lower than for any other region and more than 2ppts below the global average of 2.4%.

The most profitable region has been Asia-Pacific, with an average margin of 4.6%, followed by North America with 3.1%, Latin America (3.0%), Middle East (2.1%). Only Africa, with an average of 0.2%, has fared worse than Europe.

Airline operating margins by region 2009 to 2012e

See related reports:

Consolidation has helped margins in the US, while Europe still has a long tail of small airlines

One of the many possible reasons for this under-performance by Europe may be the lesser degree of consolidation, or concentration, in the market compared with other major regions. The US market has seen significant consolidation recently and the American Airlines/US Air merger (expected to complete in Aug-2013) will take the number of major airline groups from five to four in North America. Many commentators have remarked that consolidation in the US has had a significant impact on profitability through better capacity discipline.

According to the CAPA/Innovata database for the week of 13-May-2013, Europe has the highest number of airline groups, with 217, although it is only the number two region in terms of seats offered. Asia-Pacific, which has 24% more seats than Europe, has 189 airline groups, 13% fewer than Europe. Europe has a long tail of small carriers and has the lowest average number of seats per airline group among the world’s three largest aviation markets.

Number of seats offered and airline groups by region 6-May-2013 to 13-May 2013

Region 

Total
seats

No. of  
airline groups

Seats per  
airline group

Asia-Pacific

29,710,473

189

157,198

Europe

23,944,737

217

110,344

N America

19,564,276

140

139,745

Lat America

8,527,840

96

88,832

Middle East

4,813,674

123

39,136

Africa

3,049,008

105

29,038

The chart below shows the cumulative share of seats against the number of airline groups for each region. Those regions that have the most vertical ascent up the curve are the most concentrated. In Europe, a cumulative share of 25% is achieved by adding the share of the top three groups, while for North America this mark is reached by only two and in Asia-Pacific it takes four groups to reach 25%. North America arrives at a cumulative market share of 50% with only three groups, while Europe needs six and Asia-Pacific 11 to reach this milestone.

Up to the 50% mark, Europe is in the middle of the pack when comparing its level of concentration with the other regions, sitting between Asia-Pacific and North America on the chart. The other global regions are also placed either side of Europe. However, Europe’s curve flattens out as it progresses, so that it is the last region to reach 90%, needing 48 airline groups, compared with 45 for Asia-Pacific and only 16 for North America. Again, Europe’s long tail of small players becomes apparent.

Cumulative share of seats versus number of airline groups: 6-May-2013 to 13-May 2013

The concentration ratio and the Herfindahl-Hirschman Index

The simple way to measure the level of concentration in an industry is to look at the concentration ratio, which just adds up the combined market share of the top few companies in the industry. There is no rule that says how many should be included, but five is a typically chosen number. The market share can be measured by sales value, units sold, employment or any other relevant indicator. Airline seats offered are a simple and easy to obtain indicator.

A further measure of market concentration is the Herfindahl-Hirschman Index (HHI), which is calculated by squaring the percentage market share of each firm in the market and summing these numbers. The index would be 10,000 if a market were a pure monopoly (100 squared). The lower the index the more competitive the market is, while a high number indicates market concentration and possible monopoly power.

The HHI approach has the advantage that it gives more weight to larger players, whereas the concentration ratio does not distinguish between markets where the top five all have an equal share and those that are dominated by one or two very larger players. In the UK, Office of Fair Trading/Competition Commission merger guidelines suggest that a market with a HHI of more than 2,000 can be characterised as highly concentrated.

North America is most concentrated, Europe third

On both the simple top five concentration ratio and the Herfindahl-Hirschman Index based on share of seats, North America is the most concentrated market and Europe is the third least concentrated among the six regions of the world. Interestingly, given that Asia-Pacific is the most profitable region by operating margin, its market concentration is the lowest among the six IATA regions. None of the regions is close to the level that could be called highly concentrated.

Measures of market concentration for the main global regions by seats: 6-May-2013 to 13-May-2013

 Region

Top 5 
concentration ratio

HHI
Index

N America

69%*

1,089**

Lat America

53%

767

Middle East

52%

791

Europe

45%

524

Africa

36%

420

Asia-Pacific

31%

328

Asia-Pacific is more concentrated when looked at as separate sub-regions

Asia-Pacific differs from the other main IATA regions in that it is not a homogeneous market, but really consists of a number of different markets. Europe is dominated by airlines in the EU and the European Common Aviation Area, which is a single market with a growing number of players (mainly LCCs) that operate across the entire market. North America is dominated by the US, which is a single homogeneous market.

The other regions, Latin America, Middle East and Africa, are not really single markets, but are relatively small by comparison with the three larger regions and their aviation markets are concentrated in countries that have larger airlines. This means that there are only a small number of significant markets in each of them, while each of the Asia-Pacific sub-regions is significant in its own right (with the possible exception of Central Asia).

If we look at measures of market concentration for the Asia-Pacific sub-regions, we get much higher figures than for the region as a whole. So, for example, Air China only has 8% of seats in Asia-Pacific, but it has 14% in Northeast Asia. The Qantas Group’s share of Asia-Pacific is 4%, while its share of Southwest Pacific is 36%. In fact, the Southwest Pacific sub-region is more concentrated than North America and Central Asia is equal to North America on the HHI.

Measures of market concentration for the sub-regions of Asia-Pacific by seats: 6-May-2013 to 13-May-2013

 Sub-region

Top 5
share

HHI Index

Southwest Pacific

75%

1,779

South Asia

61%

884

Central Asia

55%

1,088

Northeast Asia

54%

724

Southeast Asia

46%

600

Margins do appear to be correlated with market concentration

In order to test the theory that margins may be correlated with market concentration, it would be useful to have data on operating margin by sub-region, but this is not available. Nevertheless, sticking with the main global regions and removing Asia-Pacific from the line of best fit, the following scatter plots lend some support to the theory.

Although Asia-Pacific as a whole has a concentration ratio of 31%, its component sub-regions all have ratios significantly higher than this and so its ‘true’ position on these charts could be argued to lie much further to the right of the point shown.

Average operating margin 2009-2012 versus top five market share by seats: for 6-May-2013 to 13-May 2013

Average operating margin 2009-2012 versus Herfindahl-Hirschman Index based on market share by seats: 6-May-2013 to 13-May 2013

What deals might make a difference in Europe?

So, if there is a structural benefit to be gained from further consolidation in Europe, what might be the potential deals that make a difference? The long tail of small carriers should probably be left alone as such transactions would be of marginal impact. It is interesting to compare Europe with North America, which are both of a similar size in terms of total seats and which both have a top five that are fairly clearly set apart from the rest.

Top 20 airline groups in Europe by seats: 6-May-2013 to 13-May 2013

Top 20 airline groups in North America by seats: 6-May-2013 to 13-May 2013

In North America, each of the top five is bigger than its counterpart in Europe in terms of seats. However, outside the top five, the rest of the top 20 North American groups are smaller than the equivalently ranked European groups. Thus, North America has more market power concentrated in the top five, but, in spite of this, the third and fourth ranked players are merging. This comparison, based on size alone, would suggest that there may still be scope for deals among the bigger groups in Europe.

Size of the Top 20 airline groups in North America and Europe by seats: 6-May-2013 to 13-May 2013

Hurdles to deals among the big European airline groups

If any two of Europe’s Big Three legacy flag carrier groups were to merge, they would be similar in scale to the AA/US Air merger by number of seats.

Setting aside any potential competition authority concerns, the problem currently is that the Big Three all have more restructuring of their own to do before they could be ready to contemplate further mergers.

Moreover, although there is a single market in Europe, it is still not fully homogeneous and national cultures and characteristics still play a role, both in terms of consumer preference and management style. It also remains very rare for flag carriers to operate from bases outside their own country, despite the EU's freedom of establishment and the example of many LCCs.

The big deals that have taken place already in Europe (Air France-KLM, IAG, Lufthansa’s acquisitions of SWISS and Austrian) have all preserved the national carriers that made up the transaction and sought synergies without attempting to create a single carrier.

The airlines that do operate across national borders and cultures in Europe are the LCCs, but they have generally preferred to grow by organic means. The two big ones, Ryanair and easyJet, which are in the top five overall by seats, have very different models and a deal between the two is inconceivable. A deal between one of them and one of the Big Three legacy carriers is also very improbable. While IAG recently acquired LCC Vueling, it already had a significant stake in it and IAG group company Iberia was a co-founder of Clickair, which merged with Vueling in 2009.

See related report: IAG profit guidance is dropped after first quarter loss, but can it still reach its previous target?

Some second tier European groups could be targets

That leaves the second tier of airline groups. Assuming that the big groups successfully complete their restructuring and their appetite for acquisition returns, they are likely to focus on targets that have also completed their own restructuring, or have at least shown that they have a sustainable model that can be profitable. They are also likely to prefer deals that do not have aeropolitical complications (such as traffic rights issues) and this probably means that their interest will be confined to EU/ECAA groups.

This would probably exclude Turkish Airlines from an outright acquisition (setting aside the issue of the Turkish Government’s 49% stake in the flag carrier), but a closer relationship with Lufthansa, possibly including an equity stake, may be a possibility – perhaps a reason for Emirates' CEO Tim Clark offering conciliatory words towards the German authorities and to Lufthansa. SAS has been a potential Lufthansa acquisition target for many years, but the consensus among the Big Three seems to be that it would be better to let the complex Scandinavian company play out the drama of restructuring or disappearing than to bid for it.

airberlin group is in a restructuring phase and, through selling a 29% stake to Etihad, has effectively taken itself out of play. Perennially loss-making Alitalia is 25% owned by Air France-KLM, who shows no interest in increasing its stake and is also unlikely to sell to a rival. The Italian national carrier seems more likely to be a candidate for consolidation by market exit eventually.

A number of other carriers in the top 20 are LCCs that are likely to prefer to retain their independence. SAS may possibly have some interest in merging with Norwegian, but it is highly unlikely that the feeling is mutual.

An outlier deal on the probability scale, but not unimaginable, would be for Ryanair to buy Wizz Air. Ryanair does not typically do acquisitions (although it has tried to buy Aer Lingus three times) and is anyway doing well in Central/Eastern Europe, but Wizz Air would accelerate this process for it and its unit costs are closer to Ryanair’s than any other carrier in Europe. Aer Lingus has not attracted a counter-bidder over the years that it has been under (or between) bids from Ryanair.

TAP Portugal’s stalled privatisation process may restart this year, but Avianca Brazil is thought to be the most likely bidder. Flybe’s losses, poor labour productivity and niche business model probably take it off the list of targets for most, but a deal with Finnair that goes further than their existing relationship is a possibility.

Finnair itself could possibly be an interesting target for oneworld partner IAG, or even Lufthansa or Air France-KLM as it is profitable and operates in a defendable niche. The Finnish Government owns 55.8%, but has said it might support moving to a reduced holding if Finnair found a willing partner.

Going much further than the top 20 brings airlines that would not significantly add to one of the big groups in terms of size. The game-changing deals that would affect the industry structure and potentially improve profitability for all, in other words between members of the Big Three, look to be a distant prospect currently.

Meanwhile, alliances, restructuring and waiting for European economies to improve will continue to be the preoccupations for Europe’s airline managers.

In light of the scarcity of options locally, the answers may lie in combinations further afield – and perhaps in inbound investments rather than Europeans expanding. Several Chinese airline groups are already looking at European acquisitions; All Nippon Airways has made public its intention to invest in foreign airlines; and the Gulf carriers, led by Etihad, have global ambitions, along with the potential to achieve them.

In the meantime, financial under-performing for Europe's airlines would seem to be a given.

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