07-Nov-2018 8:28 AM

Icelandair buys WOW air, creates a powerful competitor

Analysis

Icelandair's purchase of its low cost Icelandic competitor WOW air was a surprise, but reflects considerable industrial logic. Both offer Europe to North America connections via their Reykjavik hub and both have grown rapidly (although Icelandair is slowing this year). Icelandair is a full service carrier, whereas WOW air is a low cost airline (CAPA estimates that WOW air's unit cost, or CASK, is 35%-40% below Icelandair Group's).

The two overlapped on 19 routes, representing 49% of Icelandair's seats and 70% of WOW air's seats this summer. However, overlap based on possible one-stop Europe-North America connections is lower, giving scope for both to continue to grow as separate brands - as they will. They will have a very high combined share of Icelandic capacity but in a European context, Icelandair had only 0.3% of all seats touching Europe in summer 2018 and WOW air had just 0.2%.

Strong competition, rapid growth and rising fuel prices have weighed on both airlines' financial results. Icelandair had one of the highest operating margins in Europe in 2015 but one of the lowest in 2017, and profits are falling again in 2018, whereas WOW air is expected to record a second successive annual loss this year.

This deal should help both to better profitability at the same time as creating a more sustainable competitive force on the North Atlantic.

Summary

Icelandair's purchase of WOW air reflects industrial logic as both airlines offer Europe to North America connections via their Reykjavik hub.
Both airlines have experienced strong competition, rapid growth, and financial challenges.
The two airlines have a high point-to-point overlap on 19 routes, but overlap based on possible one-stop Europe-North America connections is lower.
The deal is subject to shareholder and regulatory approval, and competition authorities are likely to scrutinize it.
WOW air had planned an IPO, but rising fuel prices and challenging market conditions have made it difficult.
The deal offers opportunities for both airlines to improve profitability and create a more sustainable competitive force on the North Atlantic.

Summary

Iceland is a high growth market but Icelandair is slowing in 2018 and is losing seat share. The financial performance of both airlines is suffering.
Point-to-point overlap between Icelandair and WOW air is high but overlap based on possible Europe-North America one-stop connections is lower.
Competition authorities are likely to scrutinise the deal.
WOW air had planned an IPO, but conditions have become more difficult.

Purchase is subject to shareholder and regulatory approval

On 5-Nov-2018 Icelandair Group announced an all-share purchase of WOW air, subject to due diligence and the approval of its shareholders and competition authorities. WOW air's founder, CEO and sole shareholder will receive 272 million shares in Icelandair Group, which is 5.4% of the total.

The two airlines will continue to operate under separate brands, following a pattern set down by many other groups that combine distinct full service and low cost offers under common ownership.

Iceland is a high growth market, but Icelandair is slowing in 2018

Iceland has enjoyed rapid growth in its aviation market in recent years, although growth is slowing a little this year. OAG schedules data indicate that total seat capacity will be up by 13% year-on-year in 2018, compared with a five-year compound average growth rate (CAGR) of 21% pa.

WOW air has grown at a five year CAGR of 28% pa, versus Icelandair Group's CAGR of 11% pa, and other airlines have collectively grown at 29% pa.

In 2018 the Icelandair Group, the country's biggest operator, is growing seats at only 4% and will have 5.7 million seats. WOW air is expanding capacity at 28% in 2018, when it will have 3.8 million seats.

Other airlines are also growing rapidly, collectively increasing by 13.3% to 2.6 million seats this year.

Iceland: annual seat capacity, 2012 to 2018*

Icelandair is losing seat share in Iceland

Although Icelandair has grown rapidly, its slower growth versus WOW air and others means that it is losing share.

Data from OAG indicate that Icelandair Group will have a 47.1% share of all seats to/from Iceland this year, a reduction from 51.4% in 2017 and 80.4% in 2012 (the year that WOW air launched).

WOW air's 2018 seat share is projected to be 31.3%, up from 27.6% in 2017. Other airlines have collectively increased their share to 21.6% in 2018 from 20.9% in 2017 and 15.4% in 2014.

Iceland: share of annual seat capacity for Icelandair Group and WOW air, 2012 to 2018*

Financial performance of both airlines was suffering

Icelandair Group has undoubtedly felt the competitive impact of WOW air's rapid growth. Its 2017 operating margin fell to 3.5% from 9.2% in 2016 and 11.9% in 2015, when it had been one of Europe's most profitable airlines.

Its 9M2018 net profit fell to USD1.8 million from USD77.2 million a year earlier, not helped by higher fuel costs and the competitive environment having prevented price increases that might help to offset them.

Icelandair Group's slower growth this year is aimed at providing breathing space to restructure and rebuild towards improved profitability. Nevertheless, even with slower growth, load factor on its international flights fell by 2.3ppts, to 81.2%, in the first 10 months of 2018.

WOW air has also felt the impact of its rapid growth and strong competition. It reported a loss of USD13.5 million for FY2017, compared to a profit of USD30 million for FY2016 - in spite of a 58% increase in revenue that amounted to USD486 million.

WOW air is expected to report another loss for 2018, albeit a narrower one than in 2017, and to return to a small profit in 2019.

Europe and North America dominate route network from Iceland

Europe (representing 59.5% of international seats in the seasonal peak week of 30-Jul-2018) and North America (40.0%) dominate the route network from Iceland.

In summer 2018 capacity to Europe flattened, with WOW air's growth offset by Icelandair's contraction.

Nevertheless, on a five-year view, Iceland-Europe capacity in the peak summer week of 2018 was up by 58% versus 2013, with WOW air's seat numbers up by 175% and Icelandair's up by 37%.

Capacity to North America continued rapid growth in summer 2018, with seat numbers up by 28% year-on-year in the week of 30-Jul-2018, according to data from OAG. Icelandair's growth was 10%, but WOW air's was a massive 51%.

WOW air is now the second largest LCC on the North Atlantic, after Norwegian.

On a five-year view, weekly capacity to North America grew almost threefold in the week of 30-Jul-2018 versus the equivalent week of 2013. Icelandair more than doubled its capacity (an increase of 128%) and WOW air grew by a factor of almost 11 times compared with the equivalent week of summer 2015 (it only launched routes to North America in Mar-2015).

Point-to-point overlap between Icelandair and WOW air is high

Point-to-point overlap between Icelandair and WOW air is high but overlap based on possible one-stop Europe-North America connections is lower.

Based on analysis of data from OAG for the week of 30-Jul-2018, the two airlines overlapped on 19 routes this past summer, out of a total of 60 unique routes operated between them. Nine of the overlapping routes are to Europe and 10 are to North America.

The 19 routes represent 42% of Icelandair's 45 routes and 56% of WOW air's 34 routes this summer.

In terms of capacity overlap, 49% of Icelandair's seats were on routes also operated by WOW air and 70% of WOW air's seats were on routes also operated by Icelandair in summer 2018.

Icelandair and WOW air: share of each network that overlaps with the other, week of 30-Jul-2018

A CAPA analysis report published in Jul-2018 gave details of the capacity of each airline on routes to Europe and North America, highlighting all the overlapping routes.

The nine overlapping routes to Europe this summer were Copenhagen, Amsterdam, Paris CDG, London Gatwick, Frankfurt, Stockholm Arlanda, Dublin, Brussels, Milan Malpensa.

The 10 overlapping routes to North America this summer were Boston, New York Newark, New York JFK, Chicago, San Francisco, Toronto, Baltimore/Washington, Montreal, Dallas/Fort Worth and Cleveland.

See related report: Icelandic aviation: Icelandair vs WOW air

Overlap based on possible Europe-North America one-stop connections is lower

Both airlines operate strategies aimed at using the hub to offer connections between Europe and North America. The overlap is lower when the number of possible one-stop connections is considered.

Based on Icelandair's 24 destinations in Europe and 21 in North America, it can offer 504 one-stop airport pairs between the two continents (21 times 24), while WOW air can offer 270 (18 airports in Europe times 15 in North America).

The number of overlapping airport pairs is 90 (nine in Europe times 10 in North America).

This means that only 18% of Icelandair's Europe-North America one-stop airport pairs overlap with WOW air. For WOW air, the overlap on this basis is 33%.

This does not take into account how well the two airlines' schedules facilitate connections, but it suggests that there is perhaps more scope for both airlines to operate from the same hub than implied by the initial analysis of point-to-point overlap.

Competition authorities are likely to scrutinise the deal

The overlap between the two airlines may attract the attention of competition authorities. On a point-to-point basis, their combined share is high (78.0% of all seats to/from Iceland, 87.6% on Iceland-North America and 67.9% on Iceland-Europe, based on OAG data for the seasonal peak week of 30-Jul-2018).

However, the core of both businesses is connecting traffic on the North Atlantic. Icelandair and WOW air's combined share of seats on the North Atlantic was just 3.8% in summer 2018, when they were respectively ranked only the 12th and 13th largest airline groups by seats in this market.

Moreover, there are still plenty of other competitors. Iceland is served by 29 airlines in total, including 25 on routes from Europe and nine from North America, and the North Atlantic has 62 airlines operating (source: OAG, week of 30-Jul-2018).

WOW air had planned an IPO, but conditions have become more difficult

Until recently, WOW air had been planning to float its shares via an IPO some time in the next 15 months or so, but it seems that Mr Mogensen's confidence in the success of such an offering was hit by rising fuel prices.

Investors in an IPO like to see a track record of profitability or, at the very least, a credible pathway to achieving sustainable profits. The combination of higher fuel costs and fierce competition may have blurred this too much for an IPO to succeed.

In an email to employees Mr Mogensen reportedly said the sale to Icelandair "was not part of the original game plan" (Bloomberg, 05-Nov-2018). He added: "This year in particular has been extremely challenging compared to the incredible growth and success that we enjoyed during prior years. External conditions have continued to deteriorate and the outlook for many airlines has gotten extremely rough".

Nevertheless, as recently as Sep-2018, Mr Mogensen said that the possibility of a merger with Icelandair was an obvious one to ask, commenting that the two airlines could rationalise the network and leverage the situation a lot better. Although he said this was a "no-brainer", he was then doubtful that a merger would ever happen.

The deal offers something for both

The deal offers a chance for Icelandair and WOW air to adopt a much more coordinated approach to network growth.

Although both will continue to operate as a separate brands with a different market positioning, this may lead to some route rationalisation and a more rational and segmented approach to route expansion.

It should also provide the opportunity to reduce costs in centralised functions and capital expenditure. WOW air is currently an Airbus operator (3.5 years average age, according to the CAPA Fleet Database), whereas Icelandair operates Boeing equipment (21.1 years average age).

However, the combination should improve the bargaining position with both manufacturers, even if it limits the possible deployment of aircraft across the two networks.

For Icelandair, which had adopted a more defensive stance in the face of the onslaught of competition from WOW air, the deal offers the possibility to retrench and rebuild its profitability. For WOW air, the deal gives it a more secure financial backing for its continued high growth.

For both there will be challenges. In any merger or acquisition the execution is the key to success. In particular, managing the potential culture clash between the two will be crucial.

A CAPA SWOT analysis on WOW air in Sep-2017 identified overexpansion and the central importance of Mr Mogensen as the LCC's greatest risks. A merger with Icelandair, foreseen by CAPA in that report, offers the best way to manage both of these risks.