15-Mar-2013 5:30 PM

Lufthansa: why being the best of the Big Three is not good enough

Analysis

Lufthansa is the most consistently profitable of the Big Three European legacy flag carrier groups and the only one to make a positive operating result in 2012. With 236 aircraft on order and a strong balance sheet that should facilitate funding these deliveries, it appears to be in a league of its own in Europe. However, group operating profit, which fell from EUR820 million in 2011 to EUR524 million in 2012, has been on a downward path since 2007. Results at the core Lufthansa Passenger Airline fell into loss, making it the group's weakest performer in 2012, a shocking reinforcement of the need to change.

Lufthansa is taking radical steps to restructure non-hub short-haul routes using its LCC subsidiary Germanwings after similarly radical restructuring at its Austrian Airlines subsidiary and is determined to push through with its SCORE cost savings programme. For 2013, it is targeting only a better operating result than last year, but its 2015 target of an operating result of EUR2.3 billion would represent its best ever three year improvement.

Summary

Lufthansa is the most consistently profitable of the Big Three European legacy flag carrier groups and the only one to make a positive operating result in 2012.
The group operating profit has been on a downward path since 2007, with the core Lufthansa Passenger Airline falling into loss in 2012.
Lufthansa is taking radical steps to restructure non-hub short-haul routes using its LCC subsidiary Germanwings and is determined to push through with its SCORE cost savings programme.
Lufthansa has a strong balance sheet with high levels of liquidity and low net debt.
The group has seen relatively strong passenger capacity growth over the past 10 years, but this has been boosted by acquisitions.
Lufthansa is targeting a higher operating result in 2013 and aims to reach an operating result of EUR2.3 billion in 2015 under its SCORE programme.

Lufthansa was the only one of Europe's Big Three with a positive operating result in 2012

The Lufthansa Group saw a fall in its operating result in 2012 to EUR524 million, from EUR820 million in 2011. No dividend was proposed for only the second time since 2004. Nevertheless, it was the only one of Europe's Big Three legacy flag carrier groups (the other two being IAG and Air France-KLM) to post a positive operating result in 2012 and it has been the most consistently profitable of the three through the cycle, achieving a positive result for each of the past 10 years.

The improvement in net profit was mainly due to the sale of shares in Amadeus and the sale of bmi.

Deutsche Lufthansa financial highlights 2012

EUR million except where stated	2011	2012	Change
Revenue	28,734	30,135	4.9%
Operating result	820	524	-36.1%
Operating margin %	2.9	1.7	-1.2ppts
Net profit	-13	990	-
Cash	3,998	4,966	24.2%
Gross debt	6,440	6,919	7.4%
Net debt	2,328	1,953	-16.1%
Equity	8,044	8,298	3.2%
ASK (millions)	258,263	259,861	0.6%
RPK (millions)	200,376	204,775	2.2%
CTK (millions)	10,866	10,203	-6.1%
Passenger load factor %	77.6	78.8	1.2ppts

RASK (EUR cent)*	7.95	8.38	5.3%
CASK (EUR cent)**	9.54	9.96	4.4%
CASK (EUR cent)**	7.11	7.12	0.1%

Profits on a downward path driven by the passenger business

However, setting aside the dramatic slump and recovery in 2009 and 2012 respectively, Lufthansa's operating result has been on a downward path since the peak pre-crisis year of 2007 after rising strongly from 2003 to 2007.

Deutsche Lufthansa revenues, net profit and operating profit (EUR million) 2003 to 2012

The pattern of a rising group operating result to 2007 and a downward trend since then largely reflects the performance of the Passenger Airline Group segment, which is the largest of Lufthansa's divisions and comprises the individual passenger businesses of Lufthansa itself, Germanwings, SWISS and Austrian Airlines. In 2012, this segment made an operating profit of EUR258 million, down from EUR349 million in 2011. Within the segment, Lufthansa's own passenger business was the worst performer, with an operating loss of EUR45 million, compared with profits of EUR191 million at SWISS and EUR65 million at Austrian Airlines.

This was Austrian's first positive result since its acquisition by Lufthansa in 2009, reflecting the success of its restructuring which saw operations transferred into its subsidiary Tyrolean Airways. Although SWISS was again the best performer, its operating result fell by EUR68 million, partly due to the strong Swiss franc hitting revenues. The progressive transfer of Lufthansa's non-hub European flights to LCC subsidiary Germanwings from this year is aimed at improving the result of the core Lufthansa business.

Looking at the operating result of the other segments, the Logistics (cargo) division has been very volatile and its heavy loss in 2009 almost brought the whole group into an operating loss. By contrast, the MRO division (Maintenance, Repair and Overhaul) has been very steady in its profitability. The Catering segment, while only a small contributor to group profits, has also avoided an operating loss over the past 10 years. IT Services has made losses in this period, most recently in 2009, but nothing like the scale of its losses in 2003 and 2004 and typically is a low margin business for Lufthansa.

Deutsche Lufthansa operating profit by business segment (EUR million) 2003-2012.

Lufthansa's balance sheet is strong

In terms of its balance sheet, Lufthansa has a reputation for a prudent approach. It has high levels of liquidity and low net debt. The group has consistently covered its capital expenditure needs out of operating cash flow (and, on occasion, asset disposals). Its gross liquidity at the end of 2012 was almost EUR5 billion, equivalent to two months of group revenues and much higher than its minimum target of EUR2.3 billion.

For a number of years before 2009 it had a net cash position and its net debt of just under EUR2 billion at the end of 2012 gave it a fairly low gearing ratio (net debt to equity) of 24%. It makes very little use of operating leased aircraft and so its adjusted net debt, which includes capitalised operating leases, would not be much different.

Deutsche Lufthansa development of net debt and cash 2003-2012

High historic capacity growth boosted by acquisition, but much slower in 2012

The group has seen relatively strong passenger capacity growth over the past 10 years, at an average of 8.6% p.a., but this has been boosted by acquisitions (eg SWISS consolidated from 3Q2007, Austrian from 3Q2009). The underlying average growth rate for passenger capacity growth of the Lufthansa airline over this period is around 5% p.a.

In 2012, it was much slower at only 0.6% for the group. Passenger load factor was on an upward path until 2007, since when it has oscillated between the levels of around 78% to 80%, suggesting that further gains may be a challenge (although further load factor increases have been seen in Jan-2013 and Feb-2013).

Deutsche Lufthansa development capacity (ASK, million) and load factor (%) 2003-2012

In 2012, the Lufthansa Passenger Airline Group saw yield growth of 3.7%, assisted partly by currency movements (without currency effects, yield was up by 1.0%) and also by the tight capacity control. Yield growth was strongest on the Americas, reflecting a capacity cut of 0.4% to the region.

Deutsche Lufthansa change in capacity (ASK), yield (revenue per RPK) and load factor (%) by geographical region 2012

RASK-driven revenue growth in 2012

Group revenues grew by 4.9% in 2012, driven by the Passenger Airline Group, which accounted for 78% of total revenue. This revenue growth was mainly due to higher RASK, itself a combination of yield and load factor gains. The cargo business saw a fall in revenues of 8.7%, with cargo traffic volume down 6.1%. The importance of cargo to the group remains on a long term downward trend, falling to 8.9% of group revenue in 2012 from 13.6% 10 years earlier (and around 17% in the mid to late 1990s).

Lufthansa's freighter fleet of 18 MD-11Fs has not grown for a number of years; in 2006 there were 19 MD-11Fs and in 2003 Lufthansa had 22 freighters (14 MD-11Fs and eight Boeing 747Fs).

Lufthansa Technik, the group's MRO business, is the world's leading independent provider of commercial aircraft maintenance services, with 61% of its revenues from customers outside the group. Its revenues fell slightly in 2012, but this was due to lower sales to the group and its external revenues grew by 5% and its operating result increased.

Deutsche Lufthansa revenues (EUR million) 2011 and 2012

	2011	2012	Change	% of 2012 revenue
Passenger Airline Group	22,290	23,559	5.7%	78.2%
Logistics	2,943	2,688	-8.7%	8.9%
MRO	4,093	4,013	-2.0%	13.3%
IT Services	599	609	1.7%	2.0%
Catering	2,299	2,503	8.9%	8.3%
Consolidation adjustment	-3,490	-3,237	-7.2%	-10.7%
Total	28,734	30,135	4.9%	100.0%

Breaking down the group's passenger revenues by individual carrier, Lufthansa itself (including LCC subsidiary Germanwings) accounted for 73% of passenger revenues in 2012, SWISS 18% and Austrian 9%. SWISS grew its passenger revenues fastest, at 7.1%, reflecting higher capacity growth (+5.0%), whereas Austrian cut its capacity by 4.0% and Lufthansa was almost flat at 0.3%. The growth at SWISS focused on its intercontinental network.

Lufthansa Passenger Airline Group passenger revenues by carrier 2012 (EUR million)

Lufthansa more dependent on Europe for revenues than IAG and AF-KLM

Europe accounted for 46.3% of Lufthansa's group passenger traffic revenues in 2012, considerably more than for the other major European legacy flag carrier groups Air France-KLM and IAG.

The North Atlantic took the biggest share of revenues among intercontinental destination regions with almost 21%, closely followed by Asia/Pacific on 19%.

Lufthansa Passenger Airline Group geographical breakdown 2012 by share of traffic revenues (%)

Cost growth outpaced capacity in 2012, fuelled by fuel costs

Group costs grew by 4.3% in 2012, faster than the 0.6% growth in passenger capacity. Fuel costs, the biggest category at 23% of total costs, grew by almost 18%. Excluding fuel, all other costs grew by 0.8%, only just ahead of capacity growth and slower than revenue growth.

Labour expenses, which account for 22% of the total, grew by 5.6% in spite of a fall in average group headcount of 0.6%, due to some extent to currency movements, higher pension costs and restructuring costs (which should lead to future benefits).

Deutsche Lufthansa operating costs 2011 and 2012, EUR million

Costs	2011*	2012	Change	% of 2012 revenue
Fuel	6,276	7,392	17.8%	23%
Other raw materials, consumables etc	2,127	2,157	1.4%	7%
Fees and charges	5,000	5,167	3.3%	16%
Operating leases.	136	113	-16.9%	~0%
Other material costs	3,192	3,117	-2.3%	10%
Staff costs	6,678	7,052	5.6%	22%
Depreciation	1,722	1,839	6.8%	6%
Other costs	5,293	4,885	-7.7%	15%
Total	30,424	31,722	4.3%	100%

Labour productivity trends slip

Although Lufthansa Group average headcount fell in 2012, labour cost productivity measures deteriorated.

As noted above, the trends were distorted by impacts that should not recur, but management will not want to see further deterioration in 2013. Revenue productivity improved, but costs will need to be the main focus.

Deutsche Lufthansa group labour productivity measures 2011 and 2012

	2011	2012	Change
Total full time equivalent headcount	119,084	118,368	-0.6%
Total labour cost EUR million	6,678	7,052	5.6%
Employee cost per employee (EUR)	56,078	59,577	6.2%
ATK per employee	343	338	-1.2%
Employee costs per ATK (EUR cent)	16.37	17.60	7.5%
Revenue per employee	241,292	254,587	5.5%

In order to make closer comparison with other airlines that do not have such a wide range of non-flying business (eg maintenance and catering) that have large numbers of ground-based personnel, we also look at labour productivity for the flying segments of the Lufthansa Group.

On this analysis, Lufthansa looks more efficient than the other major European flag carrier groups, but, again its measures were trending in the wrong direction in 2012 on the cost side.

Lufthansa Passenger and Cargo segment labour productivity measures 2011 and 2012

	2011	2012	Change
Total full time equivalent headcount	59,518	60,258	1.2%
Total labour cost EUR million	4,221	4,303	1.9%
Employee cost per employee (EUR)	70,920	71,410	0.7%
ATK per employee	685	665	-3.0%
Employee costs per ATK (EUR cent)	10.35	10.74	3.8%
Revenue per employee	423,956	435,577	2.7%

The Lufthansa Group's fleet has shrunk

Lufthansa Group's fleet has an average age of 11.2 years and consists of 627 aircraft, down from a peak of 722 in 2009, the first year that saw Austrian and bmi consolidated into the group. The group currently has 236 aircraft on order, of which 34 will be delivered in 2013. A further long-haul aircraft order is being considered and may be placed later this year.

The focus of new aircraft will be to replace older ones, rather than significant growth in the fleet. Lufthansa plans on average to grow at half the expected market growth rate in Europe to 2025.

Deutsche Lufthansa Group aircraft in service year end 2003 to 2012

Deutsche Lufthansa Group fleet at 31-Dec-2013 and outstanding orders*

In addition to the orders noted in the tables above and below, on 19-Mar-2012, Lufthansa announced an order of 108 aircraft for the group, consisting of six 777-300ERs for SWISS, two A380s and 30 A320s for Lufthansa Passenger Airlines and a further 70 A320/321neo (still in negotiation). These aircraft are scheduled for delivery between 2015 and 2025, with no further delivery details currently specified.

Deutsche Lufthansa Group deliveries 2013 to 2018*

Only 1% passenger capacity growth and a higher operating result in 2013

In 2013, the Lufthansa Passenger Airline Group plans capacity growth of 1.0% overall, with short-haul cuts of 2.6% and long-haul growing by 2.9%. In the northern hemisphere summer season, these trends will be more pronounced: short-haul down 2.9% and long-haul up 4.1%, for a total of 1.5% capacity growth.

Lufthansa Group's capacity growth in 2013 will not stem from fleet growth, but, rather, from two other factors. First, increased number of seats per flight (though reducing business class seats and increasing economy seats on many long-haul routes and through the use of A380s and 747-800s on old 747-400 routes) and, second, higher aircraft productivity.

In terms of a financial target for 2013, Lufthansa is aiming for a higher operating result than the EUR524 million recorded in 2012. Given a target under the group's SCORE programme to reach a EUR2.3 billion operating result in 2015, this goal for 2013 would seem an absolute minimum.

Lufthansa Passenger Airline Group capacity growth plan 2013

Corporate restructuring and the SCORE cost programme; LSG Sky Chefs for sale?

Lufthansa's CEO Christoph Franz took time at the 2012 results presentation to remind those present of the corporate restructuring measures and disposals since 2011. Lufthansa has been reported to be working on the sale of parts of its LSG Sky Chefs catering business, so further such measures could be on their way. He also emphasised the group's cost saving programme SCORE, which made EUR618 million of savings in 2012 and under which the group has an ambitious target to reach an operating result of EUR2.3 billion in 2015.

The 2013 target under SCORE is for EUR740 million of savings and the most significant project is the development of the new Germanwings starting on 01-Jul. Mr Franz believes it will offer Europe's best price-performance ratio among the low-cost airlines and contribute EUR200 million of improvements to the group result by 2015.

The group did not report separate results for Germanwings in 2012, but its 2011 results showed that its average revenue per passenger was around EUR91 (and that it made a loss), compared with the Lufthansa Passenger Airline Group's average traffic revenue per passenger of EUR121 on European routes, so it should be lower priced than the parent group.

However, these figures compare with EUR58 for Ryanair, and EUR75 to EUR80 for Vueling and easyJet. It remains to be seen if its performance (however defined) will be significantly superior to these LCCs.

Corporate restructuring since 2011 and SCORE programme measures

Deutsche Lufthansa SCORE programme targets to 2015

Lufthansa has controlled ex fuel CASK but fuel costs and volatile RASK trends undermine this

As for many other European airlines, the bounce-back from poor profitability in 2009 (losses for most; a low, but positive, operating result for Lufthansa) was driven by improved unit revenues in 2010. Lufthansa has seen a broadly upward trend in RASK since then, although it fell in 2011 and remains below the levels reached in 2008.

It has focused with some success on unit costs. Although these have risen quite sharply since 2009, this has mainly been due to fuel cost increases. Ex fuel unit costs have been fairly stable since 2009, but Lufthansa has not managed to match the steady fall in ex fuel CASK seen from 2006 to 2009.

Deutsche Lufthansa - index of operating cost per ASK and fare revenues per ASK (each indexed to 100 in 2010)

The chart below compares Lufthansa's unit costs and average sector length with those of a number of other European competitor airlines. The individual passenger airlines of the Lufthansa Groups are shown, in addition to the unit cost position of the Group as a whole (but excluding the maintenance, catering and IT segments from the cost base).

This chart demonstrates, first, how short Lufthansa's average sector lengths are compared with the other legacy groups.

Lufthansa is much more dependent on domestic and European traffic than any other big European flag carrier group. This reflects the fact that its main hub, Frankfurt, is based in a relatively small city with small O&D market, meaning that Lufthansa must generate feed from a much wider catchment area to sustain its long-haul network. It is also due to the relative size and de-centralised nature of Germany compared with other major European countries, such as the UK and France, which means that there is more point-to-point domestic traffic connecting major non-hub cities.

The chart also demonstrates that the group needs to make further efficiencies if it is to become more competitive. Lufthansa Group airlines' unit costs are currently broadly in the pack of legacy carriers, but significantly above the LCCs and above the more efficient legacy carriers such as Finnair and Aer Lingus.

It no doubt generates higher unit revenues than these carriers, but, as noted above, RASK cannot be relied upon. The Tyrolean restructuring at Austrian, the Germanwings-based restructuring at Lufthansa and other SCORE projects demonstrate that management understands this.

Unit costs (cost per available seat kilometre) and average sector length for selected European legacy and low-cost carriers 2012*

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