22-Oct-2014 3:00 PM

Lufthansa's planned new lower cost long-haul airline must avoid legacy issues

Analysis

Lufthansa's recent confirmation that it is adding premium economy cabins to its entire widebody fleet is one of a number of recent initiatives aimed at making its long-haul operations more competitive. The most radical, and certainly the highest profile, of these developments is its plan to establish a new lower cost airline, under a new brand and aimed at the long-haul point to point leisure market.

First announced in Jul-2014, Lufthansa's Executive Board presented more details of this long-haul plan to its Supervisory Board in Sep-2014. Although operating a fleet of only seven aircraft out of a Lufthansa-branded widebody fleet currently in excess of 100 aircraft, the success (or otherwise) of this new operation could have far-reaching consequences across the group.

A recent CAPA report suggested that Lufthansa's short-haul LCC, Germanwings, has too many legacy issues, but that the more flexible and lower cost pilot contract at its Eurowings subsidiary gives it options for growth. Lufthansa must ensure that its new lower cost long-haul airline avoids all legacy issues that might be a drag on its cost efficiency.

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Short-haul: Germanwings and Eurowings have pioneered the 'Wings' concept

In short-haul, Lufthansa has owned a lower cost subsidiary airline, Germanwings, for many years and has been growing it strongly since Jul-2013. This has been the subject of many analysis reports by CAPA including:

The grouping of Lufthansa's low-cost projects under the loose 'Wings' name stems from the long established Germanwings and from another Lufthansa group company Eurowings. Key to the 'Wings' concept and to Lufthansa's awakening to its potential is the opportunity to establish new operations with little or none of the legacy issues that have bloated the cost base in the group's core activities. Eurowings has a separate pilot contract to that of the rest of the group, giving lower costs and greater flexibility.

For many years a supplier of regional aircraft capacity to the Lufthansa brand, Eurowings is now becoming a wet lease supplier to Germanwings. It will also spread the group's short-haul low-cost operations into its two other 'home countries', Switzerland and Austria.

Having a platform that avoids the group's legacy labour contracts, and which Lufthansa can expand, not only gives it a lower cost vehicle for growth, but also allows it to put pressure on unions representing its mainline employees to recognise the need for savings.

New long-haul low-cost airline under a separate brand

Lufthansa's 'Wings' concept broadly stands for point to point, lower cost, operations. Its plans for a new long-haul airline in this part of the market, mainly aimed at private travellers, were first outlined in Jul-2014.

It seems that Lufthansa was growing increasingly frustrated by its inability to move its cost base low enough to compete in this segment, but had become emboldened by its more aggressive stance towards short-haul point to point. A further catalyst may have been new group CEO Carsten Spohr, who was appointed on 1-May-2014 and who has brought a new sense of urgency to Lufthansa.

The plan announced in Jul-2014 involved setting up a long-haul airline under a new brand name from the end of 2015, initially deploying seven Boeing 767s or Airbus A330s. The launch is now targeted for autumn 2015 and the aircraft choice has now been made in favour of Airbus A330-300 equipment. Lufthansa said in Jul-2014 that it would switch the fleet into new generation widebodies, either 787s or A350s, if the concept proves to be viable.

Lufthansa's biggest hub, Frankfurt, will not be a base for the new long-haul airline. Munich, Duesseldorf, Cologne-Bonn and Hamburg were under consideration in Jul-2014.

In its Sep-2014 statement, Lufthansa said that it plans to start with three aircraft in Munich, Duesseldorf or Cologne. This report will analyse this planned operation in more detail below, after touching on other initiatives that Lufthansa is taking in order to capture some of the superior growth opportunities it sees in the long-haul leisure segment.

Re-equipping Lufthansa aircraft for leisure routes

Lufthansa says that "other intercontinental traffic approaches will be developed in order to once again profitably fly leisure travel-dominated routes using the Lufthansa brand".

Specifically, Lufthansa plans to reconfigure up to 14 Airbus A340-300s from its long-haul fleet so that they are "optimised for leisure travel" from the start of the 2015/2016 winter schedule. The new configuration will have no first class, but will have 18 business class seats, 19 premium economy seats and 261 economy seats.

The airline hopes that this sub-fleet will combine lower costs with the "high-quality travel experience of a Lufthansa flight, with high service standards and comfort levels". It expects that this will allow it to serve new leisure routes and to continue in markets that it would otherwise have to exit without a lower priced offer.

Adding premium economy to Lufthansa's widebodies

Lufthansa is also equipping its entire long-haul fleet with a premium economy cabin. All of its Boeing 747-8s will be modified by 20-Nov-2014 and a total of 101 Lufthansa long-haul aircraft (A380, A340-600, A340-300, A330, Boeing 747-8 and 747-400) will be equipped with the new cabin by late summer 2015.

Lufthansa has not previously operated with a premium economy class, which offers the opportunity both to economy passengers to trade up and for business class passengers to trade down. It is reducing the number of seats in first class and business class and so this initiative will provide more opportunities to trade down than to trade up.

Broadly, it looks like another effort to offer a more competitively priced product, while retaining a premium-like perception.

Long-haul 'Wings' will have a largely different network to Lufthansa's

Returning to Lufthansa's plans for its new lower-cost long-haul airline, it is specifically aiming to target private travellers on point to point leisure routes. This has significant implications for its network choices. Avoiding its main hub at Frankfurt, with its relatively low immediate O&D catchment area, its strong business traveller focus and its high proportion of transfer traffic (not to mention high airport charges), seems a sensible decision.

As noted above, Lufthansa plans to launch the new brand at Munich, Duesseldorf or Cologne, although Munich's relatively high costs, slot congestion and night time curfew may count against it. It has not yet announced any planned destinations, but it will focus on destinations that "promise above-average growth in the leisure travel segment and that round out the Lufthansa Group airlines' current route networks."

This most probably means secondary cities, rather than major hubs, that may not be in the current Lufthansa network. However, the new airline's network could also include major hubs such as Bangkok, which is also a major leisure destination.

Few other genuinely long-haul low-cost airlines

At the moment, airlines that are genuinely both long-haul and low-cost are few and far between, although there are no clear-cut definitions of long-haul or of low-cost. Fortunately, CAPA keeps a record of airlines that are categorised as low-cost carriers (based more on product features than on a strict analysis of costs). Very few of them have long-haul operations.

Long-haul probably means an average trip length in excess of something like 4,500km. Certainly, the few global airlines that follow a pure long-haul business model operate at distances around this mark and longer.

Examples include Emirates and Etihad (both around 4,800km), Singapore Airlines (5,000km) and Virgin Atlantic (7,200km excluding Little Red). London to New York, one of the world's shorter long-haul routes, is around 5,500km. The Lufthansa Group's own long-haul operations have an average trip length of around 6,800km.

CAPA's database contains only three LCCs with an average trip length of more than 4,000km. These are Thai AirAsia X (4,200km), AirAsia X (4,700km) and ArkeFly (7,600km). The latter, a TUI subsidiary, is primarily a charter carrier serving tour operators owned by its parent.

Top 10 global low-cost carriers ranked by average trip length (km)*

Airlie	Average trip length km
ArkeFly	7,624
AirAsia X	4,723
Thai AirAsia X	4,151
Scoot	3,276
Sunwing Airlines	2,759
Mihin Lanka	2,589
SunExpress Germany	2,527
Virgin America	2,393
WOW air	2,261
Air India Express	2,215

This means the AirAsia X Group is the world's only genuinely long-haul scheduled LCC business model. AirAsia X has the lowest CASK of any airline in the world, partly reflecting its long-haul model, but also built on the advantages of low labour costs with no legacy issues. Nevertheless, it has had a varied record with regard to profitability.

Singapore Airlines subsidiary Scoot has a shorter average trip length, about 3,300km. But it has a significantly larger average trip length than LCCs which operate narrowbody aircraft. Scoot and AirAsia X are the only LCCs with all-widebody fleets. There are currently five other LCCs which operate widebody aircraft as well as narrowbody aircraft: Australia-based Jetstar, Norwegian, Philippines-based Cebu Pacific, Saudi Arabia-based flynas and Brazil-based Azul.

Widebody LCCs: current fleet and outstanding commitments for additional new aircraft: as of end Sep-2014

Airline group	Launch year	Current fleet	Outstanding orders/commitments
AirAsia X	2007	25 (22 A330-300s, 2 A340-300s, 1 A330-200)	97 (50 A330-900neos, 37 A330-300Es, 10 A350-900s)
Jetstar	2006	14 (7 A330-200s*, 7 787-8s)	7 (787-8s)
Scoot	2012	6 (6 777-200s*)	20 (10 787-9s, 10 787-8s)
Norwegian	2013	7 (7 787-8s)	7 (6 787-9s, 1 787-8)
Cebu Pacific	2013	5 (A330-300s)	1 (A330-300s)
flynas	2014	3 (2 A330-300s, 1 A330-200 wet leased)	0 (only committed to additional wet leases)
Azul	2014	2 (A330-200 delivered but not yet operating)	5 (A350-900s)
TOTALS		62	137

The only current LCC widebody operator in Europe, Norwegian Air Shuttle, has an average trip length of about 1,300km. Norwegian has used its new fleet of 787s to add long-haul routes to its previously Europe-only network over the past year. Its current long-haul network has destinations in the US in addition to Bangkok.

Norwegian's long-haul model encompasses taking advantage of lower labour costs that are available globally, rather than exclusively employing Scandinavian, or even European, staff. Norwegian has also seen its profits suffer since entering the long-haul markets.

Ryanair CEO Michael O'Leary is one of the industries most noted and successful champions of low costs. He has been mulling the possible establishment of a long-haul low-cost airline for several years, but has always refrained from proceeding with his plans. As CAPA has previously observed, the fact that one of the industry's greatest cost cutters does not yet see an opportunity to enter the long-haul LCC arena suggests that the concept is yet to be proved (certainly as regards sustainable profitability).

Long-haul 'Wings' will need much lower unit cost to offset downward price pressures

Lufthansa does not claim to be planning a truly low-cost long-haul operator. Rather, it hopes that the new airline will be lower cost than its existing long-haul operations.

The presence of genuine low cost operators in some long-haul markets and Lufthansa's own emphasis on price as a key dimension of competition for its new project will add to the price sensitive nature of the long-haul point to point leisure segment in which it will operate. This will make it crucial that the new airline is at least as cost competitive as the most efficient long-haul FSCs.

Comparison with operators such as Singapore Airlines, Emirates and Turkish Airlines suggests that Lufthansa will need to lower its long-haul CASK by somewhere in the region of 30% to match their average unit costs. These airlines average unit costs are based on a combination of leisure and other routes and Lufthansa's new airline will probably need even lower levels of CASK than this to be competitive in the leisure segment.

Cabin reconfiguration can contribute significantly towards lower unit cost

Cabin reconfiguration, with the addition of more seats, can probably go a significant way towards achieving the requisite level of unit cost, although we do not yet know how many seats Lufthansa plans for the A330-300 fleet in the new operation. Mr Spohr told analysts at a presentation on strategy in London in Jul-2014 that the new airline would include a premium cabin, but it may be assumed that this would not involve first class and possibly only a premium economy cabin, with no business class.

Comparison with Lufthansa's plans to reconfigure up to 14 Airbus A340-300s from its long-haul fleet for leisure operations under its own brand suggest that the A330s for the new airline might have 30% more seats than the 221 under its existing A330 three cabin configuration. All other things being equal, this would reduce costs per seat by 23%, leaving further savings to be achieved from other sources, including labour.

AirAsia X operates A330-300s with 377 seats in a two cabin configuration, including 12 lie flat beds in business class. The arithmetic of this configuration is such that it would offer Lufthansa a 40% cost per seat reduction (all other things being equal). It would be a strong sign of intent (and also a surprise) if Lufthansa were to push its new airline this far towards a genuine low-cost model.

New generation aircraft may eventually replace A330s in long-haul 'Wings'

Seat densification can certainly make a contribution, but this is already a trend in the industry, particularly on leisure routes. Charter airlines have very high levels of seats per aircraft. A low-cost operation must also achieve low aircraft operating costs by seeking the most efficient technology.

Norwegian operates Boeing 787-8 equipment on its long-haul routes, with 291 seats including 32 in premium economy. This new generation aircraft offers cost per seat savings of around 15% to 20% over the previous technology (for the same configuration) and, together with the Airbus A350 and A330-300neo represents the equipment of choice for long-haul low-cost operators in the future. AirAsia X is the launch customer for the new A330-300neo and also has small number of A350s on order.

If Lufthansa's new long-haul airline can show signs of being viable with its A330-300 fleet, this will give it confidence that it could become even stronger with the additional savings offered by more efficient new aircraft.

SunExpress is a possible vehicle for the new long-haul airline

Lufthansa said in Jul-2014, and reiterated in Sep-2014, that it was talking to its Star Alliance partner Turkish Airlines about the possibility of using SunExpress as a platform for its new long-haul airline, although it said that this was only one option. LCC SunExpress is 50-50 jointly owned by Lufthansa and Turkish and focuses on leisure routes between Turkey and Europe, in particular Germany.

SunExpress' business gives it experience in a number of the features that will be part of the planned new airline. It operates in point to point leisure markets under a separate brand from either of its parents. In addition, previous CAPA analysis suggests that SunExpress is a genuinely low-cost operator.

See related reports:

Operationally, it deviates from the profile of Lufthansa's new project in two ways. First, its routes are long in European terms, but not genuinely long-haul. Together with its subsidiary SunExpress Germany, its average trip length is around 2,200km, Second, it operates a fleet of Boeing 737 aircraft and so has no experience with Airbus equipment or widebodies.

If Lufthansa does establish its new airline through SunExpress, this would help towards improving relations with Turkish Airlines, which soured in 2013.

The Star partners pair broke off their codeshare agreement and ceased mutual FFP arrangements as Lufthansa expressed anxiety over Turkish Airlines' strong growth in secondary German cities, which was taking some connecting traffic away from Frankfurt and into Istanbul. Turkish itself has significant experience in global long-haul markets and also has a very efficient cost base and could bring its know-how to any new SunExpress long-haul venture.

Disconnecting the brand from the labour agreement

Mr Spohr told analysts at the Jul-2014 presentation that an important element of the Wings concept, from a cost point of view, is to "disconnect the brand from the labour agreement". As with its increasing use of Eurowings, this allows both a lower cost base in the new operation and demonstrates to unions in the core business that growth is possible through lower cost platforms.

In addition to achieving lower labour costs through, a new brand allows a lower frills product without damaging the Lufthansa brand. It could also be an opportunity in markets where Lufthansa has not historically been strong, but where a fresh new brand could be more appropriate.

"The combination of our core brands' focus on quality and the premium sector, and the development of new platforms for the leisure travel sector, which is experiencing dynamic growth but is also price-sensitive, is our way of working towards a successful future for the Lufthansa Group airlines," said Mr Spohr in Lufthansa's Sep-2014 statement.

Creating options for its own future

This last comment from Mr Spohr may have the appearance of being directed to customers, but the message is equally plain to Lufthansa's workforce. If new brands with lower costs can be made to work in the leisure sector, perhaps this will embolden Lufthansa further to try new things in the rest of the group.

It is also a positive sign that Lufthansa is looking for ways in which it can create its own options for its future development. In recent years, the group has sometimes appeared to be preoccupied with looking for someone else to blame for its challenges, in particular the Gulf carriers.

As Qatar Airways CEO Akbar Al Baker said recently of Mr Spohr, "I'm sure he envies me very much, because we don't have to take the crap of the unions. … He has a difficult job to do but always friends can disagree, and I disagree that Gulf carriers are the cause of the pressures that Lufthansa has" (Bloomberg, 17-Sep-2014).

Lufthansa is the only one of the European Big Three groups not to have entered some form of cooperation with the Gulf Three (while its relationship soured last year with Turkish, the 'fourth Gulf carrier'). These competitors have strong global networks, high quality products and enviably low costs. To a large extent, it is the competitive pressures that they have brought into the market that have forced Lufthansa into seeking a lower cost long-haul operation.

Mr Spohr's focus on shaping Lufthansa's own destiny, rather than complaining about competition, is to be welcomed.