Lufthansa and Etihad: equity tie up could further align mutual strategy, but marriage unlikely

Lufthansa could increase capital with Etihad, taking 30-40% stake

The potential for credibility comes from the fact that two airlines have quietly explored this option in the past. They are now reported to be considering the possibility of Etihad taking a 30%-40% stake in Lufthansa through a capital increase. The Il Messaggero article suggested that they were also considering merging the two airlines in a second stage. A union between Lufthansa and Etihad may also involve Etihad's equity associates such as Alitalia and airberlin, according to conjecture reported in the press in recent weeks.

Lufthansa has declined to comment on what it calls "speculation", but Reuters subsequently published an article in which it said that sources familiar with the matter denied that talks about an equity investment were taking place. Reuters also reported that "A source familiar with state-owned Etihad also said Abu Dhabi would not want to pay for a stake in Lufthansa".

The environment for Lufthansa and Etihad has profoundly changed. They have more in common than they did in the past

For too long, at a time when progressive airlines have been engaging in deep partnerships, Lufthansa has considered every competitor an enemy. Even some airlines in Star Alliance felt more apart than they did together, based on Lufthansa's chosen few friends. Now however, there is a changing wind at Lufthansa management, in part to seek new growth platforms independent of Lufthansa's strong unions. There are also factors outside Lufthansa that require a more strategic response.

Lufthansa and Etihad need to appease their governments

Lufthansa: Berlin affords advantages to Lufthansa (Gulf traffic rights are not liberalised) but the German government is increasingly frustrated with Lufthansa's quest for protectionism. Berlin wants Lufthansa to find its own solution, and even specifically suggested that Lufthansa partner with a Gulf airline.

Etihad: Ministerial changes at Abu Dhabi, which owns Etihad, mean the government is questioning Etihad's investment strategy, as well as Etihad's own performance. Lufthansa is initially helping Etihad with airberlin, and reports indicate later cooperation could result in Alitalia being helped as well. Italy is an important market for Lufthansa, but Ryanair is now in the process of expanding rapidly there.

airberlin's tamed existence better than an unfettered easyJet, Ryanair

airberlin is the lesser of the evils for Lufthansa. Besides the German government not wanting Lufthansa to have a local monopoly, market forces would mean that easyJet and Ryanair would expand in Germany. With much lower costs than airberlin and easyJet's increased focus on the corporate market, they would inflict more damage on Lufthansa than airberlin.

Qatar Airways and Turkish Airlines are bigger challenges

In the time that Lufthansa has grappled with Etihad's European investments and Etihad's own intercontinental traffic flows, Qatar Airways has accelerated growth and become much more of a threat.

Lufthansa has also proclaimed Turkish Airlines as a competitor. As CAPA has previously noted, Etihad brings potential benefits to Lufthansa's intercontinental network while being smaller than Qatar, and not as directly present in Lufthansa's home markets in the way that Turkish is. Turkish is advantaged by being closer to other European countries than Gulf States. That allows unrestrained narrowbody service to the region. Strong local traffic flows to/from Turkey make it easier to discount sixth freedom traffic.

The Gulf impact is not confined to Lufthansa: Etihad feels it, too. Etihad investing in Lufthansa would give Etihad a partner, ensuring Abu Dhabi continues to receive the economic catalyst from an aviation presence but with lower capital costs. Abu Dhabi is tightening finances in the wake of reduced oil revenue from lower prices. Even without that adjustment, Etihad may have needed further capital to accelerate growth and maintain market share. Etihad will not catch up or exceed Qatar Airways, let alone Emirates, but there was a widening gap.

See related report: Lufthansa and Etihad bedfellows - at last - but unions may make marriage a distant prospect

Comparison of Gulf airlines and Turkish Airlines by market with Lufthansa Group (and Singapore Airlines for Australia/NZ): week commencing 19-Dec-2016

Source: CAPA - Centre for Aviation and OAG.

Turkish Airlines and Gulf airline seat capacity in home and key source markets for the Lufthansa Group: week commencing 19-Dec-2016

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Source: CAPA - Centre for Aviation and OAG.

Codeshare announced in Dec-2016 is limited in scope

Lufthansa and Etihad announced a new codeshare in Dec-2016. In an analysis report on 17-Dec-2017 CAPA suggested that this agreement had significant symbolic importance and that a partnership between the two had potential, in the long term, to be more significant than Emirates-Qantas, Qatar-IAG or Etihad-AF-KLM.

However, the CAPA report also noted that the codeshare was limited in scope, and it urged caution in extrapolating too far at this stage. In particular, Lufthansa is codesharing only from Germany to Abu Dhabi, and is not partnering on any Etihad flights beyond Abu Dhabi. This (initial) codeshare is tactical, and not encompassing: Lufthansa gains access to Abu Dhabi, a market it has stopped serving. By not partnering beyond Abu Dhabi Lufthansa is not yet embracing Etihad's fundamental - and contentious - business proposition of intercontinental flows via Abu Dhabi.

See related report: Lufthansa and Etihad bedfellows - at last - but unions may make marriage a distant prospect

Etihad and Lufthansa initial partnership arrangements: 16-Dec-2016

Source: Etihad and Lufthansa.

Needing to solve airberlin challenge brought Etihad and Lufthansa back together

The talks between Lufthansa and Etihad that led to the codeshare coincided with the development of a wet lease agreement between airberlin and Lufthansa, which forms an important plank of the Berlin based airline's restructuring programme. Over the years Lufthansa and Etihad have held serious cooperation talks, and at one time came close to a partnership.

Lufthansa and Etihad have mutual interest in airberlin achieving a positive outcome. Etihad has a minority stake in airberlin but is its largest shareholder. Lufthansa and others might argue that with other forms of capital not officially equity, Etihad is effectively airberlin's majority owner. Navigating the complexities and sensitivity of such a complex transaction reflects that Lufthansa and Etihad management can work together, look beyond their past, and make some compromises for a shared and stronger future. They can now tackle even deeper, and more challenging, areas for cooperation - or, according to the local report, even a merger.

Partnerships need sound numbers to create interest, but what typically makes or breaks deals is the people component. Etihad and Lufthansa have shown - to the surprise of many - that they can work together.

Practical impediments challenge, and even limit, potential scope

Nevertheless, there is a background of cultural and attitudinal differences between the two, with Lufthansa often publicly attacking what it regards as an unlevel playing field favouring the Gulf airlines. In addition, there are practical impediments both to Etihad's taking a 30% stake in Lufthansa and to a full merger between the two airlines.

These include German takeover rules that would require Etihad to bid for the whole company if it bought a stake of 30% or more. In addition, a capital increase of more than 20% requires shareholder approval at a general meeting.

A full takeover of Lufthansa by Etihad would be next to impossible, since it would cause Lufthansa to lose its German and EU nationalities and, as a result, its international traffic rights. It may be possible for the two to establish a jointly owned holding company, which would then become the new owner for both airlines.

Traffic rights could be questioned for protectionist purposes

Traffic right requirements on paper may mean that local majority ownership and control of each may have to continue to be held by nationals of the respective nations.

In practice, however, foreign countries have seldom questioned the nationality of ownership or control of another country's airline. So long as that airline is designated by its home country as being local, foreign countries have generally accepted the designation. That means, for example, that Brazil accepts Germany saying Lufthansa is a local airline; Brazil does not carry out its own investigation or designation. Likewise Germany accepts TAM as a Brazilian airline since Brazil has designated it as such; Germany does not look into TAM's complicated ownership/holding.

There is a handful of incidents where a country has questioned the 'localness' of a foreign airline. But in every major case known the purpose was not routine or to uphold laws, but rather was protectionist: by the claim that an airline was not really a local airline to its own country, its growth could be impeded or presence removed all together. Such incidents resulted in solutions other than adjusting local ownership/control.

It would be dangerous for countries to start questioning the nationality of foreign airlines. Nonetheless, if Lufthansa were to be seen as a UAE airline there may be some countries looking to seize on that for protectionist reasons. Moreover, in the recent past the EU has investigated even the minority holdings of Etihad and others in European airlines in order to satisfy that they do not contravene restrictions on non EU ownership and control.

See related report: Airline ownership & control. Why might Europe uphold something its officials call "stupid"?

Lufthansa management bandwidth would be tested with greater Etihad involvement

A further practical obstacle is the sheer amount of activity already on the agenda for both airlines, mostly Lufthansa. Lufthansa has its hands full with integrating the newly acquired Brussels Airlines and the 38 aircraft wet leased from airberlin into its Eurowings low cost brand. (That itself is just one challenge for Eurowings.)

See related report: Lufthansa folds Brussels Airlines into Eurowings, keeping dual brands. LH has many balls in the air

Lufthansa's unions may also be a hurdle to such a closer tie with Etihad, or even to anything that threatens the status quo. Of course, it is for management to determine Lufthansa's strategic priorities and to manage the group accordingly. The limited nature of the new codeshare agreement with Etihad reveals the need to proceed with some caution in order not to rush labour organisations.

For its part, Etihad is busy managing its own growth as well as overseeing significant restructuring programmes at both Alitalia and airberlin - its two largest European equity investments. Further cooperation with Etihad adds work but also, likely, solutions.

There are benefits for both from a deeper relationship

Although there are challenges, there is certainly a good deal of strategic logic for Lufthansa in developing a deeper relationship with Etihad, just as IAG is doing with Qatar Airways. The Doha based airline has built up a 20% stake in IAG through buying shares on the market and is now entering a joint venture with British Airways, building on codeshares with BA and Vueling.

See related reports:

• British Airways-Qatar Airways form Europe's first Gulf airline JV, showing some oneworld flexibility
• Qatar Airways and Vueling to codeshare as LCC partnerships establish new models

Lufthansa's sixth freedom connecting business over Frankfurt, particularly to/from Asia and the Middle East, has long suffered from Gulf competition. In response, Lufthansa has developed joint ventures with key Asian partners such as Singapore Airlines, ANA and Air China, but something more is arguably still needed.

Etihad does not significantly expand destinations or capacity across the region (there are exceptions in certain markets, like Bangkok) but it does give Lufthansa a much lower cost provider than it or JV partners can offer. With Lufthansa cooperation (feed, codeshares, frequent flyer alignment) Etihad could even grow further in some areas.

Lufthansa's existing JVs, not to mention its membership of Star, may inhibit its working more closely with Etihad but initially this can be tackled on a market by market basis. Lufthansa could also benefit from the intra European consolidation that might result from the possible inclusion of airberlin and Alitalia in any deal with Etihad.

For its part, Etihad has invested significant sums, often in multiple rounds, in its European equity partner airlines, but still finds that the two biggest - airberlin and Alitalia - are loss making and in need of further restructuring. As at airberlin, the next restructuring may need another airline besides Etihad.

See related reports:

• Alitalia: "everyone has to pull in the same direction" - ongoing issues, and viability is at stake.
• Airberlin: airline's latest, more radical, restructuring gets help from TUIFly and Lufthansa

It is attractive for Etihad to have a solution that can prevent the need for further investment. Etihad may like to safeguard its existing investments, but it should also be prepared for exit strategies that allow it to depart with its head high and face intact.

The Lufthansa Group, although somewhat lukewarm in profit margin, has a strong balance sheet and may be an attractive financial partner for Etihad. Etihad and Abu Dhabi have seldom invested in airlines for pure return. (The same is true for many other airlines, such as Qatar Airways investing in IAG and LATAM.)

Investing in Lufthansa gives Etihad a partner for the future, allowing Abu Dhabi still to have exposure to aviation but not needing large capital to maintain relevancy in the face of a growing Qatar, to say little of Emirates. Etihad and Abu Dhabi have long positioned the airline to be the smallest of the three Gulf superconnectors, but it was not imagined that the gap between Etihad and Qatar/Emirates would be so big.

At the very least, the current speculation reflects the desire by both Lufthansa and Etihad to explore ways in which they can deepen their relationship.

The merger rumours may be misplaced, but the initial codeshare and discussions about a closer partnership of some kind will force other airlines to reevaluate old antagonisms and see if they can find new partners. Many airlines will need to take radical steps to maintain their position. Through flexibility and innovation, some airlines can get ahead.