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Lufthansa's long-haul low-cost Asian operation. A range of partner options. Part 1

27-Mar-2013

Lufthansa has suggested it may look to a long-haul, low-cost solution to meet its future Southeast Asian growth goals. The German flag carrier's historically strong position on Europe-Asia Pacific is steadily being eroded by competition from Gulf carriers and others with more competitive cost bases. An additional player, LCC Norwegian Air Shuttle, is also about to enter the fray over the pole, with a Bangkok service. Our analysis suggests that the Lufthansa Group may need to cut its unit costs on long-haul by as much as 30% in order to be competitive and to secure its long term future in the region.

Lufthansa’s major European Big Three rivals, after years of sulking, are meanwhile now cuddling up to the Gulf carriers; IAG has brought Qatar Airways into oneworld and Air France-KLM is codesharing with Etihad. Unfortunately, the toughest Gulf competitor, Emirates, wants to continue to stand alone. And China, still largely dormant internationally, is starting to stir.

Given Asia Pacific’s position as the biggest air passenger market and one of those with the highest forecast growth rates, Lufthansa needs a new direction. It is apparently considering whether to form a partnership with another carrier or start its own new low-cost operation. The latter is a big ask. There is a host of potential partners though; but Lufthansa would have to be careful how many toes it stands on, with such an option.

Establishing a new long-haul carrier with a much lower cost base from scratch would not be easy and nobody has really managed it before on any long-haul routes from Europe. Moreover, Lufthansa would presumably want to maintain the integrity of its global network and its full service product and branding. It would also have to be wary of upsetting too many of its Star Alliance and other bilateral partners – not to mention its mainline brand (and associated unions).

One thing Lufthansa does have is a Star Alliance partner, Turkish Airlines, with a competitive cost base, sizeable network and respected product and with whom it already cooperates in SunExpress. There is also potentially a number of existing (and other) low-cost operations at the Asian end that might see considerable strategic value in linking with Europe's most powerful long-haul airline.

Lufthansa Group is the leader on Europe to Asia Pacific

The Lufthansa Group is the leading participant by seats on routes between Europe and Asia Pacific, a region of historic strength for it. Although it has more passenger traffic and revenues on the Americas, destinations in Asia Pacific account for three of its top five routes by ASKs (Frankfurt to Singapore, Tokyo and Beijing).

Top 20 Airline groups Europe to Asia Pacific ranked by Seats: 25-Mar-2013 to 31-Mar-2013

Rank

Airline Group

Total Seats

1

Deutsche Lufthansa AG

137,107

2

Air France-KLM S.A.

126,016

3

Aeroflot - Russian Airlines Group

75,091

4

Turkish Airlines Group

69,191

5

Singapore Airlines

64,746

6

Thai Airways International

63,888

7

International Airlines Group

59,606

8

Cathay Pacific (Group)

46,294

9

Air China Limited

42,958

10

Finnair Group

40,676

11

Malaysian Airline System

29,208

12

Korean Air Group

29,092

13

Japan Airlines Co., Ltd.

27,700

14

Virgin Atlantic Airways

21,180

15

Air India Limited

21,028

16

All Nippon Airways Co., Ltd

20,536

17

Jet Airways Group

20,052

18

Vietnam   Airlines Corporation

17,806

19

Qantas   Group

16,022

20

China   Southern Air Holding Company

15,136

Lufthansa Group top 10 international routes by ASK: 25-Mar-2013 to 31-Mar-2013

And so is the Star Alliance

Lufthansa’s Star Alliance is neck and neck with SkyTeam in terms of share of total seats in Asia Pacific (both are on around 20%), but in the leading position when it comes to international seats. Moreover, Star is a clear leader in seats from Europe to Asia Pacific, with 34% of the total, although cooperation between Lufthansa and Asian partners such as Air China and SIA is not always very close.

Asia Pacific capacity share (international seats) by alliance: 25-Mar-2013 to 31-Mar-2013

Europe to Asia Pacific capacity share (seats) by alliance: 25-Mar-2013 to 31-Mar-2013

 Alliance

Seats 

Share 

Star

438,626

34%

Skyteam

302,004

23%

oneworld

247,392

19%

Others

302,586

23%

Total

1,290,608

100%

The Lufthansa Group is slowly bleeding away its Asia Pacific strength

The Lufthansa Group is a major player to the Asia Pacific region, both in its own right and with its Star Alliance partners. So why does it need a re-think of its approach to the region?

From 2010 to 2012, the Lufthansa Group’s total scheduled traffic (measured in RTKs) grew by 6%, but its traffic to the fast growing Asia Pacific region remained flat.

The region’s share of Lufthansa’s scheduled traffic fell from 32% to 30%. Analysis of the group’s revenues tells a similar story: total traffic revenues increased by 14% from 2010 to 2012, but Asia Pacific traffic revenues grew by only 2% and their share of group traffic revenues fell from 24% to 21%. The group’s share of AEA passenger numbers and RPKs also fell over the period.

Given that the region is the biggest in the world in terms of air passengers and one of its fastest-growing, Lufthansa’s apparent inability to participate fully in the growth is disturbing for what is still the number one group between Europe and Asia Pacific by seats.

Lufthansa Group division of traffic (total RTK) and traffic revenue by region (%): 2010 and 2012

Lufthansa Group passenger traffic share of AEA traffic (RPK and passenger numbers) to Asia Pacific (%): 2010 and 2012

Growth forecasts for Asia Pacific underline its crucial nature

Asia Pacific passenger traffic will grow at a 6.7% average annual rate from 2012 to 2016, compared with 5.3% for the world in total, according to IATA forecasts. This will make it the second fastest growing region, but as it is also the largest region by passenger number, with 29% in 2011 (forecast by IATA to reach 33% in 2016), it is a crucial region for carriers from Europe with claims to be global players.

IATA forecast of CAGR in passenger traffic by region (%): 2012-2016

Asia Pacific share of world passenger traffic 2011 and forecast 2016 (%)

Long-haul profits are no longer secure

The importance of Asia Pacific to Lufthansa is underlined further by the ongoing problems faced by the legacy flag carriers in making money out of their European operations.

Although regional profits are not reported, it is broadly accepted that their short/medium-haul networks struggle to make a profit against the increasingly fierce competition from LCCs. This explains the radical restructuring being pursued by Lufthansa in its continental activities, but also highlights the urgency of protecting profits on long-haul. In broad terms, long-haul has been cross-subsidising short-haul. Losing the future profit margin on Asian routes becomes crucial.

See related article: Lufthansa, Air France-KLM, IAG adopt short haul initiatives to combat LCCs: Airlines in transition

The Lufthansa Group saw a fall in operating profit in 2012, mainly due to a fall in profits in the passenger segment, which included losses in the Lufthansa-branded passenger business. This suggests that any profits on long-haul are declining, emphasising the need for the company to make changes.

Lufthansa is not cost competitive, but Star partner Turkish Airlines is

The chart below shows unit costs (operating costs per available seat kilometre) and average sector lengths for a number of leading European carriers and a small sample of non-European competitors. In some cases (Lufthansa and Turkish Airlines) it is possible to use regional traffic and revenue data to estimate separate data for unit costs on long-haul and short/medium-haul.

What is clear from the chart is that, while Lufthansa Group’s constituent airlines are broadly cost-competitive with the major European flag carrier groups overall, they are high-cost by comparison with leaner European legacy carriers such as Aer Lingus and Finnair and very inefficient on long-haul when compared with competitors such as Emirates – and even Virgin Atlantic.

Lufthansa is also at a striking cost disadvantage against alliance partners such as Turkish Airlines, Singapore Airlines and Air China. Star Alliance cooperation has not been sufficient for best practice on costs to be shared and spread, but Lufthansa may need to find a way to make use of opportunities that are virtually under its nose.

Lufthansa has certain structural cost disadvantages against Asian and Middle Eastern carriers in terms of wage rates and other employee costs and also in airport charges. Carriers such as Virgin Atlantic, which is essentially a point-to-point airline, do not have the network-related fixed costs that the Lufthansa Group carries. 

Lufthansa will now also face indirect additional competition from Norwegian Air Shuttle, the European LCC that is launching long-haul services this summer. Currently an entirely short-haul player, its unit costs are among the lowest in Europe. Although it will be a small player initially, if successful it could take some share from Lufthansa of traffic that currently connects over Frankfurt from other parts of Europe to Asia.

While there may be good reasons for the Lufthansa Group’s higher unit costs against a range of competitors, its ability to compete will ultimately be eroded unless it can make a dramatic downward change to its costs. Benchmarking estimated unit costs for Lufthansa Group’s long-haul operations against Virgin Atlantic, Emirates, Singapore Airlines and Turkish Airlines long-haul, Lufthansa needs to cut its CASK by around 30%. This will have to be done, either unilaterally or – more realistically – with the help of a partner.

Unit costs (cost per available seat kilometre, EUR cent) and average sector length for selected European and other network carriers 2012*

History of long-haul low-cost is not encouraging – but hybridisation offers room to move

Lufthansa is considering a new long-haul low-cost operation, but the history of the long-haul low-cost business model is patchy at best. Three North Atlantic carriers, Eos, Maxjet and Silverjet, aimed mainly at the business traveller (but with a lower cost model), collapsed in the advent of the global financial crisis. Hong Kong based Oasis, which pioneered low-cost long-haul to Europe, also collapsed in 2008. Air Asia X withdrew from its Europe routes (London Gatwick and Paris Orly) in early 2012 after recording a minus 26% margin on the region.

In spite of the Oasis failure, Asia Pacific remains the region with the most positive experience of low-cost long-haul, with Jetstar, Scoot and Cebu Pacific all occupying this niche. Nevertheless, their operations focus on intra-Asia Pacific routes and there is no really successful precedent for Europe-Asia Pacific low-cost carriers.

Lufthansa, with or without partners, would have to design the template, overcome the challenges faced by others and be the first to implement such a plan successfully. This would be far from easy, especially on a go-it-alone basis and so a joint approach with a partner may make more sense.

That said, if Lufthansa were to adopt the hybrid long-haul model increasingly favoured by the intra-Asian operators like Jetstar and AirAsia X, it would have the prospect of accepting some cost disadvantage, provided it were able to extract a higher yield profile than a "pure" low-cost model. In other words, there is low cost and there is lower cost; but the bottom line depends on the yield margin. And, if the traffic feeds Lufthansa's hub(s), there is a further flow-on.

A lower cost Lufthansa operation – differently branded, but otherwise linked into the mainline features such as connectivity and frequent flyer programme (as Qantas' Jetstar is) – may well be what the flag carrier needs.

New technology will help, but lower labour costs will be key. Finding a partner is probably the only solution

The scale of the cost challenge facing Lufthansa is significant – but at the same time, it cannot avoid the challenge, if it is to be a long term competitor.

The new generation of aircraft types can certainly contribute to lower unit costs and Lufthansa is now pondering a new long-haul order, considering the relative merits of the A350 and the Boeing 787.

According to manufacturer claims, these more efficient aircraft can lower unit costs by something in the region of 10%-15%. However, this reduction would not be enough to bring Lufthansa's costs down to a competitive level and, moreover, these aircraft will also be available to competitors that already have lower unit costs.

Lufthansa’s biggest cost category is employee costs and it seems likely that the only way to be competitive in the long run on Europe-Asia  Pacific is to make radical changes to the labour force. Given high wage rates and social security contributions in Germany and a history of industrial relations that, while not the worst in Europe, is far from permanently harmonious, this will most probably mean having employees based in Asian countries where wage rates are significantly lower than they are in Germany.

This would make it difficult for Lufthansa to establish a pure in-house new operation; culturally and from a labour perspective there are significant hurdles. This helps explain why it would be talking to partners such as Turkish Airlines about closer co-operation on Asia Pacific routes.

Turkish Airlines is one option, although less than optimal – and there is potential for conflict

In recent times, Lufthansa has moved to deepen its ties with Turkish Airlines. There is strong logic for this, quite apart from the significant end-to-end traffic flows (Frankfurt, Dusseldorf – and Vienna – are three of Turkish's top 10 routes and the jointly owned SunExpress carriers are highly active in the bilateral market); the airlines codeshare actively and have considerable synergies.

Turkish is the number four airline group on Europe-Asia Pacific, has a natural geographical advantage not unlike that of the Gulf carriers and has a cost structure that is competitive against the Asian and Middle Eastern carriers. Moreover, Turkish Airlines could benefit too from additional feed into its fast growing intercontinental network.

See related articles:

As with any partnership between large airlines, there is however always the potential for overlap and conflict of interest, especially where one embarks on a new course, such as Lufthansa envisages here. On Southeast Asian routes, each has a broadly similar schedule pattern, so theoretically a one-stop operation via Turkey would offer a potentially lower price formula. This makes for more attractive point-to-point options and Germany has a large tourist market to Thailand, also well fed by charters.

But using Turkish would do little to help Lufthansa entrench its own hub role, something that is most under threat from the Gulf airlines – and that is presumably at least part of Lufthansa's objective in considering the low cost option. Already, a considerable part of Turkish's Germany traffic is sixth freedom, with origin and destination beyond Istanbul, a factor Lufthansa would watch carefully.

Then there are the Asian partnership options...

Although Lufthansa's suggested move to adopt a low(er) cost Asian operation is relatively radical for a European airline, it is in many ways remarkable how slow European airlines have been to recognise the turmoil of new airline models – and with them, opportunities – that are sprouting in Asia.

Ever since the world's lowest cost LCC, AirAsia, pioneered the highly effective "cross-border joint ventures" that have enabled it and others after it to circumvent ownership and control restrictions in order to establish new bases, the way the intra-Asian market operates has been turned on its head. AirAsia, well on its way to becoming the region's largest airline by seats, did not exist a decade ago. That the group (embracing longhaul AirAsia X) is now operating 132 aircraft and has 387 on order – including 10 A350s and 18 A330s to join the eight it currently operates – is testimony to the importance of these cross border establishments.

Given the entrepreneurial outlook of AirAsia founder Tony Fernandes, it will not have escaped his notice that Lufthansa is scouting for partners. Nor will he have overlooked the fact that there are some very interesting permutations possible, especially as AirAsia X is currently preparing for an IPO.

Yet there is nothing – other than inertia or lack of vision – to prevent any other substantial airline from using the same model to establish in Asian countries. Australia's Qantas for example has been no slouch in this respect, with its Jetstar low-cost subsidiary now involved in local joint ventures in Singapore, Vietnam, Japan and Hong Kong. Parent airline Qantas is exploring similar opportunities for its full-service model.

There will be some chatter among Asia's full-service airlines too, some of whom might also like to form a coalition against the Gulf carriers.

In Part 2 of this CAPA review we shall explore a wider range of the potential existing operations that Lufthansa might see as valuable partners in the Asian region – as well as what its goals may be. Or what they perhaps should be.

Then, assuming Lufthansa follows through, how its main European competitors might respond....

These and similar issues are at the heart of discussion at CAPA’s second annual Airlines in Transition conference to be held in Dublin on 11/12 April. The event brings together many CEOs and other leaders from the aviation and IT industry and serves as a platform to discuss evolving airline models and trends and strategies that best address changing customer behaviour and travel industry directions.


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