19-Jun-2016 2:07 PM

Eurowings develops innovative partnership approach, but CASK reduction may not go far enough

Analysis

In a 10-Jun-2016 presentation to equity analysts in London Lufthansa's Karl Ulrich Garnadt, the executive board member responsible for Eurowings, talked of his excitement for this "very ambitious, far reaching, very important" project for the Lufthansa Group. The group is developing an innovative partnership approach to allow other airlines to join its LCC activities under the Eurowings brand.

In 2011 the combined Lufthansa/Germanwings non-hub point-to-point network served 110 destinations and offered 24 million seats, of which only approximately nine million were operated by the LCC subsidiary. In 2016 the new Eurowings network has 135 destinations and offers 26 million seats (this comprises those operated by Eurowings and those yet to be transferred from Germanwings, while none are operated by Lufthansa).

The transfer of traffic from Lufthansa to Germanwings helped to turn around losses of more than EUR200 million. Germanwings' traffic and fleet are now progressively being transferred to the lower-cost Eurowings - the umbrella brand for the group's LCC operations. Germanwings/Eurowings achieves a RASK premium compared with other European LCCs. However, its low margin suggests that this is not enough by comparison with its CASK, which will remain higher than those of other LCCs.

Lufthansa's short haul point-to-point operation has turned around under Germanwings/Eurowings

In 2012 Lufthansa's short/medium haul point-to-point operations - excluding those that operated to/from its main hubs at Frankfurt or Munich - lost more than EUR200 million.

At that time Lufthansa owned its LCC subsidiary Germanwings, but did not make extensive use of it. Germanwings carried 8 million passengers annually and was also loss-making. In 2013 Lufthansa began to transfer operations in this segment to Germanwings, airport by airport and route by route, in order to make use of its lower cost base.

By 2015 Lufthansa had decided to make another transfer of these activities - this time from Germanwings to Eurowings, whose cost base is lower still.

See: Lufthansa to Germanwings to Eurowings. Long haul and lower cost as Lufthansa seeks solutions

The combined Germanwings/Eurowings achieved a positive result in 2015, making an EBIT of EUR38 million, for a 2% EBIT margin. This return to break-even in 2015 was in accordance with Germanwings' plan set out in 2013, although it was helped significantly by lower fuel costs.

Lufthansa point-to-point* and Germanwings/Eurowings EBIT, EUR million, 2012 to 2015

Eurowings to fall back into loss in 2016; profit once more in 2017

The Lufthansa Group expects that the combined Germanwings/Eurowings operation will return to loss in 2016, due to higher "project costs". These are costs related to the start and ramp-up of operations in its long haul business and at its new Vienna base.

The plan is then for a positive result once more in 2017, when project costs will fall. Nevertheless, it seems unlikely that its profit margin will be much more than low single digit.

Eurowings development of EBIT and project costs 2015 to 2017

Germanwings/Eurowings 2015 CASK was higher than in 2011

For the first time, Lufthansa has publicly disclosed the unit cost figure for Germanwings/Eurowings. This was EUR10.0c in 2015 - 7% below its 2013 level of EUR10.8c. However, this 2015 figure is between 11% and 18% higher than the EUR8.5-EUR9.0 range estimated by CAPA for Germanwings' 2011 CASK in a report in 2013.

The increase may partly be explained by the impact of a shorter average trip length in 2015 since - all other things being equal - CASK falls as average trip length increases (and vice versa). However, according to CAPA estimates (based on OAG schedules data), Germanwings/Eurowings' average trip length in 2015 was only 6% shorter than in 2013, so this does not fully explain the CASK increase.

According to data on scheduled capacity from OAG, only 5% of the combined ASKs were operated by the lower-cost Eurowings in 2015. However, it is still somewhat surprising that the 2015 CASK was not lower, especially given that fuel prices were much lower in 2013 than in 2015.

Germanwings/Eurowings RASK and CASK EUR cent, 2013 to 2015

Germanwings/Eurowings is high cost compared with other European LCCs

In a May-2016 Analysis report on the LCC strategies of the big three European legacy airline groups, CAPA compared Eurowings' 2015 CASK with those of other European LCCs. This was based on an estimate of EUR9.8c for Eurowings, since Lufthansa had not yet published the true 2015 figure of EUR10.0c. In that report, CAPA noted as follows:

This approach indicates that the Eurowings business has a CASK that may be at least two thirds higher than Vueling's, which is close to easyJet's CASK. Eurowings' CASK is considerably more than twice that of ultra-LCC Ryanair. This much higher unit cost is only partly explained by its shorter average trip length (only 15% less than Vueling's, for example). It suggests that the term LCC really does not apply, at least not to Eurowings' old incarnation.

In 2015, the vast majority of the business now called Eurowings was still operated by Germanwings. These CASK estimates highlight Germanwings lack of cost efficiency and explain why Lufthansa no longer wants to use it as its LCC operator. This has become even more acute since Ryanair stepped up its presence in Germany.

The Germanwings platform still accounts for the majority of the production managed under the Eurowings brand. As the transfer to Eurowings production continues through 2016 and into 2017, the level of CASK for the brand should reduce significantly.

The chart below compares Germanwings/Eurowings with other European airlines in terms of its unit cost and its average trip length. Again, it highlights that it is not a true low cost carrier in CASK terms.

Cost per available seat kilometre (CASK, USc) versus average trip length (km) for Germanwings/Eurowings compared with other European airlines

Eurowings anticipates 28% ex fuel CASK reduction by 2020

Eurowings currently anticipates that its unit cost levels will fall significantly over the five years from 2015 to 2020. Its ex fuel CASK was EUR8.0c in 2015, but its plan predicts that this will fall to EUR7.2c in 2016 and EUR5.8c in 2020 - a 28% reduction from 2015.

According to the plan, between 2015 and 2020 the overhead and miscellaneous cost per ASK will fall by 40%; product CASK by 25%; ACMI CASK by 30%, and fees/charges CASK by 25%.

Eurowings ex fuel CASK development plan (EUR cent)*

CASK reduction from crew, upgauging, long haul expansion

The CASK reductions predicted by Eurowings will come from a combination of underlying cost efficiency improvements and technical factors.

The most important underlying cost efficiency improvement comes from the switch from Germanwings crew to Eurowings crew.

Although Germanwings' cockpit costs per block hour are 20% below Lufthansa's, Eurowings' are significantly lower still - 23% below Germanwings' cockpit costs per block hour.

Eurowings will also achieve cost efficiencies from the centralising of commercial and administrative functions of Germanwings and Eurowings. As its scale increases, Eurowings should also be able to negotiate better terms with suppliers such as airports, caterers and ground handlers.

The technical factors that should drive CASK down are aircraft upgauging and long haul expansion. Germanwings operates a fleet of 61 Airbus A320 family aircraft, while Eurowings still operates 12 Bombardier CRJ900s. These regional jets are being replaced by A320 family equipment (Eurowings already has 13) and this upgauging will serve to lower unit cost.

The Eurowings long haul fleet, operated on its behalf under wet-lease arrangements by SunExpress Germany, currently comprises three A330-200 aircraft. This is planned to grow to seven in 2017. The increase in average trip length resulting from Eurowings' long haul expansion is the second technical factor that will bring down its CASK.

Eurowings fleet plan

2020 ex fuel CASK target still 29% higher than easyJet's in 2015

Eurowings' 2020 ex fuel CASK target of EUR5.8c is still 29% higher than easyJet's ex fuel CASK for 2015 (year to Oct-2015) and 2.8 times that of Ryanair for the year to Mar-2016. It will probably still have a shorter average trip length than easyJet and Ryanair, although it has not disclosed a target in this respect.

Based on its planned 2020 fleet mix and data on short haul versus long haul average trip lengths from its current traffic data, Eurowings' average trip length looks likely to increase to within 10% to 20% of those of easyJet and Ryanair. This suggests that Eurowings' trip length-adjusted CASK will still be high compared with other European LCCs.

Eurowings attracts a RASK premium

Eurowings' management points out that it is positioned within the LCC segment to attract a revenue premium relative to other European LCCs. Its product includes features such as a premium cabin, and its network consists mainly of primary airports.

Moreover, it has access to a large customer base of Lufthansa frequent flyers. On top of these factors, it is developing new ancillary services to drive new revenue streams and it plans to introduce on-board WiFi from winter 2016/2017.

Eurowings positioning within the LCC segment

According to data presented by Eurowings management it is achieving a RASK premium relative to LCCs such as easyJet, Vueling and Wizz Air. Its 2015 RASK was EUR9.5c (note that this is below its CASK figure, even though it reported a positive EBIT, because the Lufthansa Group reports other operating income as a separate line item, whereas many other airlines net this off against other operating costs).

Eurowings RASK figure of EUR9.5c compares with EUR7.2c for easyJet, EUR6.5c for Vueling and EUR4.2c for Wizz Air (figures are adjusted to be comparable for A320 family aircraft, but are close to figures calculated from reported data for revenue and ASKs for each airline). This supports its claim that it is able to attract a premium within the LCC segment.

Eurowings management told analysts that the strength of demand in Germany allowed it to achieve a RASK of EUR15c in its home country, supported by a high proportion of business travellers. The CCO, Oliver Wagner, said that when Germanwings took over routes from Lufthansa the RASK fell only 2%, but the CASK reduction was more dramatic.

Eurowings vs easyJet, Vueling and Wizz Air: cycles, flight duration and RASK

But Eurowings' margin is low versus other leading LCCs

Nevertheless, its low margin compared with most other leading LCCs in Europe demonstrates that the RASK premium that it is able to generate is not yet sufficient to drive a healthy level of profitability relative to its CASK.

Eurowings achieved an operating margin of 2.0% in 2015. Among other significant European LCCs, only the Air France-KLM subsidiary Transavia reported a lower margin, with a negative 3.2%. IAG's Vueling recorded an operating margin of 8.1%.

The leading independent LCCs were significantly more profitable than all three of these legacy group subsidiaries in 2015. Ryanair achieved an operating margin of 22.4% and Wizz Air made 16.5% in the year to Mar-2016, while easyJet's margin was 14.7% for the year to Sep-2015.

Operating margins for listed European airline companies and subsidiaries (% of revenue) 2014 and 2015

Eurowings' organisational structure allows partner airlines to be added

Eurowings has established a flexible organisational structure that is designed to allow it to roll out the concept across Europe through a partnership model that could take different forms. It has established a headquarters in Cologne, with a central management team to run administration and commercial activities for all the participating production platforms under the Eurowings brand.

Under this central organisation, Eurowings Aviation GmbH, several different AOCs can be gathered to operate its route network. Starting with Germanwings and the Duesseldorf-based Eurowings Germany, it has now received approval for an AOC for the Vienna-based Eurowings Europe, while SunExpress Germany is the platform for Eurowings' long haul operations.

Beyond its existing bases in Germany and Vienna, Eurowings is open to setting up further bases in Europe. According to Karl Ulrich Garnadt, the member of the Lufthansa Executive Board with responsibility for Eurowings and Aviation Services, the main Lufthansa hubs at Frankfurt and Munich are "not off limit" for Eurowings.

Air France-KLM's Transavia has established a new base at Munich, but Eurowings has not responded. "It is only because of a lack of resource in the short term", said Mr Garnadt, adding that the Lufthansa Group would allocate resources to those businesses that were the most successful over time.

Eurowings organisational structure

'Eurowings cooperation model' envisages three possible approaches

Eurowings plans to add further operators to its network, flying a consistent product under a single brand. The 'Eurowings cooperation model' envisages partner airlines joining under one of three possible approaches.

The simplest form of cooperation is under a wet-lease/ACMI arrangement as a subcontractor to the airline management company Eurowings Aviation. This allows a quick ramp-up but does not give strong incentives for the partner beyond its hourly rate, and is Eurowings' least preferred option over the longer term.

The second form of cooperation is to become an 'ACO Partner'. Under this approach, the partner shares central admin and commercial functions with Eurowings, thereby participating in cost efficiency improvements, and it keeps its revenue - less a fee to Eurowings.

The third form of cooperation is an equity relationship between Eurowings and the partner airline. This is the closest form of partnership envisaged under the Eurowings cooperation model.

In seeking partner airlines Eurowings is considering a number of criteria. These include having a level of CASK that is competitive with easyJet's (while taking into account different stage lengths and levels of airport charges); daily aircraft utilisation rates in the region of 10-10.5 hours; labour productivity efficiency; and numerical benchmarks such as EBIT margin and return on capital. There must also be a strategic rationale and the ability to implement the partnership plan.

Eurowings management was keen to stress to analysts at the London presentation that it was not "a point of collection for ailing airlines that need to be restructured". Lufthansa and Eurowings are currently evaluating possible partners and are taking a cautious approach, particularly with regard to acquisitions/equity investments.

According to Eurowings' head of Business Development, Max Kownatzki, a low double-digit number of airlines have expressed interest in the AOC partnership approach.

Eurowings cooperation model options

Eurowings' CASK reduction plan may need to go further

By switching from Germanwings to Eurowings Lufthansa has shown that it recognises the importance of low CASK in competing in short haul point-to-point markets in Europe. The Eurowings cooperation model gives it a flexible approach to growing its LCC operations across Europe, although it also brings execution challenges.

Moreover, Eurowings' CASK reduction plan may not go far enough. It has demonstrated an ability to generate an RASK premium compared with other LCCS, but its thin margin (expected to turn negative once more in 2016) shows that the balance between its RASK and CASK does not yet allow it to achieve sustainable profitability.

Ryanair has the lowest unit cost in Europe and is the largest intra-European airline. The Irish ultra-LCC is increasing its presence in primary airports and moving its product and service offering in a more upmarket direction without significantly adding to its cost base. With Ryanair now targeting Germany for further expansion, the need is growing for Eurowings to accelerate its CASK reduction plans.