05-Nov-2012 9:30 PM

Turkish Airlines tie-up could give Lufthansa the solution it needs as profits continue to fall

Analysis

Germany's powerful Chancellor Angela Merkel was not to sit idly by and watch how Lufthansa would be checkmated in the ongoing challenge towards a new world order for the airline industry, so decided to move some of the pawns: bring Europe's largest airline group together with Europe's fastest growing airline, Turkish Airlines. The news must have come as a surprise and while nothing is decided or formally announced, a combination of Lufthansa and Turkish Airlines would make the Qatar-oneworld deal and the Etihad-Air France-KLM-airberlin codeshare agreement look like child's play. Moreover, it would keep the "subsidised" Gulf carriers at bay and halter further inroads, at least in central Europe where Lufthansa is the dominant player.

Turkey's Prime Minister Tayyip Erdogan revealed the talks of a potential Turkish Airlines-Lufthansa partnership in a speech to his ruling AK Party on 03-Nov-2012, saying he had agreed to a proposal by Mrs Merkel to establish joint management of the two carriers.

Summary

Germany's Chancellor Angela Merkel proposed a joint management of Lufthansa and Turkish Airlines, potentially creating the world's largest airline group.
A Lufthansa-Turkish Airlines partnership would keep Gulf carriers at bay and halt further inroads in central Europe.
Turkish Airlines is an alternative to Gulf carriers, pursuing similar intercontinental traffic flows.
A combination of Lufthansa and Turkish Airlines would create the world's second-largest airline group based on capacity.
The tie-up has political support at the highest level, with Merkel proposing the idea.
Lufthansa is not interested in a tie-up with Gulf carriers and prefers a partnership with Turkish Airlines.

Is Turkish Airlines an alternative to the Gulf carriers?

Lufthansa has never been shy to publicly criticise the inroads of the Gulf carriers in Europe and the European hub system, arguing they are unfairly subsidised by their governments and thus should not be granted further bilateral access. But the recent links forged by Qatar Airways/oneworld and Etihad Airways/Air France-KLM/airberlin leaves Lufthansa as the only major European airline not participating in some sort of tie-up with an expanding Middle East hub carrier.

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Lufthansa cannot ignore the structural changes taking place in the industry. A tie-up with Turkish Airlines fits better than a Gulf carrier in the Lufthansa strategy which targets profitable growth, complemented by consolidation in Europe and cooperation agreements and commercial joint ventures in strategic markets.

In reality, Turkish is equally as self-minded in its expansion strategy as the Middle Eastern hub carriers and pursues similar sixth-freedom intercontinental traffic flows. But Turkey matches the "European consolidation" tone.

Turkish-Lufthansa combination could create world's largest airline group

Turkish Airlines has already grown to become the world's eighth largest international carrier, based on current seat capacity figures, putting it ahead of Qatar and Etihad but behind Emirates (see Background information). Lufthansa is already the largest international carrier and largest airline group based on international capacity.

As a group Lufthansa is the world's fourth largest airline group, when including both domestic and international capacity. Turkish Airlines is currently the 19th largest airline group, and one of the fastest-growing in recent years.

Combining the Lufthansa Group with Turkish Airlines would create the world's second largest airline group after Delta Air Lines based on capacity, with about 3.8 million weekly seats compared to 3.9 million for Delta. Given the rapid rate of growth at Turkish, which has seen its monthly passenger and seat figures increase by about 40% over the last two years, it would not be surprising to see a combined Lufthansa-Turkish emerge ahead of Delta as the world's largest airline group in terms of seat capacity.

Top 20 airline groups based on system-wide capacity (seats per week): 05-Nov-2012 to 11-Nov-2012

Lufthansa-Turkish tie-up is logical and has political support at the higest level

The idea to bring Lufthansa and Turkish Airlines more closely together seems to have stemmed from Germany's - and Europe's - powerful political figure, Mrs Merkel.

''During my visit to Germany, Merkel made this proposal: 'Let's put Lufthansa and Turkish Airlines under joint management.' I said okay," Turkish PM Tayyip Erdogan said in a speech on 03-Nov-2012 to his ruling AK Party, Reuters reported. "This is currently among our projects and God willing we can, and will, take this joint step with Turkish Airlines and Lufthansa," Mr Erdogan said.

Both Lufthansa and Turkish Airlines are members of the Star Alliance and the carriers have a long-term relationship via SunExpress, the Antalya-based leisure airline. Lufthansa and Turkish Airlines each hold 50% of the company. During summer 2012 SunExpress operated a fleet of 28 Boeing 737-800s with a total capacity of 5292 seats, according to its website.

The planned sell-off of a further tranche of the Turkish government's shareholding in Turkish Airlines could be a straightforward way for Lufthansa to acquire a stake in the airline. The Turkish government still owns 49.12% in Turkish Airlines and has stated several times it intends to reduce this, although so far it has been non-committal on detailing the method or size of a privatisation.

Lufthansa not interested in tie-up with Gulf carrier

Although Lufthansa was courted by Etihad in 2010, senior management resisted, preferring to rely on its strength in its home market and the power of the Star Alliance grouping which it heads. This stance seems not to have changed, with Lufthansa Group chairman and CEO Christoph Franz saying during the Group's 3Q2012 results briefing on 31-Oct-2012 that the airline "has the Star Alliance, the largest and most successful airline alliance, which offers us high value-added and our customers seamless travel".

Furthermore, Mr Franz insisted "Lufthansa already offers the strongest network to Asia today, with numerous connections from Germany. From this perspective, future cooperation agreements with Gulf carriers do not seem profitable enough, neither for us nor for our customers."

Lufthansa and Turkish are currently the two largest airlines in the Europe-Asia market, based on seat capacity. Lufthansa is also the largest group in the Europe-Asia market, providing about 127,000 weekly one-way seats (includes flights operated by SWISS and Austrian) compared to about 104,000 weekly seats for Air France-KLM.

Top 10 airlines in Europe to Asia market by capacity (one-way weekly seats): 05-Nov-2012 to 11-Nov-2012

Rank	Airline		Total seats
1	LH	Lufthansa	90,768
2	TK	Turkish Airlines	67,581
3	AF	Air France	66,510
4	SQ	Singapore Airlines	64,988
5	TG	Thai Airways	63,260
6	BA	British Airways	60,320
7	SU	Aeroflot	48,907
8	CX	Cathay Pacific	45,670
9	CA	Air China	44,950
10	AY	Finnair	41,152

But Emirates and Qatar Airways is much larger than any European carrier in Asia, offering about 350,000 and 160,000 weekly one-way seats to Asia, respectively. Etihad also offers over 100,000 weekly seats to Asia.

When factoring in the broader Europe/Middle East-Asia market, a Lufthansa Group-Turkish combination would be slightly smaller than the combination of Etihad, Air France-KLM and airberlin and the combination of British Airways parent IAG and Qatar. The combination of Emirates and Qantas would be much larger than any of these three.

Capacity (one-way weekly seats) by proposed major partners in Europe/Middle East to Asia market

Rank	Airlines	Total seats
1	Emirates-Qantas	370,354
2	British Airways (IAG)-Qatar	219,594
3	Air France-KLM-airberlin-Etihad	209,419
4	Lufthansa-Austrian-SWISS-Turkish	194,263

Mr Franz recognises that the aviation industry is in a state of "upheaval" with Gulf carriers increasingly also acting as an engine of consolidation. While welcoming further consolidation, Lufthansa will only actively participate "if it is possible at eye level".

Air France and airberlin have entered partnerships with Etihad from "a position of weakness", Mr Franz assessed, pointing out that the Lufthansa Group is "not under pressure, and we can and will assess any potential partnerships very carefully".

But as the Gulf carriers continue to forge partnerships with key members of the global alliances, pressure will continue to build on Lufthansa. A tie-up with Turkish Airlines could be the most logical response. As CAPA reported in Oct-2012 following the oneworld-Qatar and Etihad-Air France/airberlin announcements:

That leaves one major European airline without a partner on this new dance floor: Lufthansa. As head of the Star Alliance, Lufthansa has occupied a prominent position as a network carrier, with a host of partner/satellite airlines. The carrier has actively resisted the expansion of the Gulf airlines into its territory, a fixation that may now see it sidelined as the powerful new entities line up.

Although Lufthansa was courted by Etihad in 2010, senior management resisted the temptation to change course, preferring to rely on its strength in its home market and the power of the Star Alliance grouping which it heads. This may now prove to have been an awkward decision. Etihad's first move was to partner with airberlin, right on Lufthansa's doorstep. Now, with a promised Air France-airberlin codeshare, the foreign intrusion becomes ever more poignant.

Lufthansa Group sustains 'insufficient' 3.1% operating margin

In politics, there never is such a thing as coincidence and thus Mr Erdogan's timing most likely was chosen on purpose. On 31-Oct-2012, Lufthansa Group announced a 13.3% decrease of operating profit for the first nine months of 2012 compared to the year-ago period and a 0.7ppts fall of the Group's operating margin to 3.1%. The Group's core and largest entity, Lufthansa Passenger Airlines recorded a meagre 0.8% operating margin for 9M2012 and is expected to end the full year with a "noticeable" operating loss.

Lufthansa Group's consolidated net earnings soared by 30% to EUR642 million in 3Q2012 and operating profit rose by 6.2% to EUR648 million on a 6.2% increase in revenues to EUR8.3 billion. Passenger revenue increased 5.5% to EUR6.9 billion while passenger numbers grew 2.6% to 29.4 million. RPKs inched up 0.6% in 3Q2012 but ASKs and the number of flights reduced year-over-year by 0.8%. As a result, passenger load factor improved 1.3ppts to 83.4%.

However, the Group's good results for the quarter ending 30-Sept-2012 proved insufficient to offset the year-over-year worsening of its 1H2012 operating result (from a EUR114 million profit 1H2011 to a EUR20 million loss in 1H2012) and the rise in costs continued to outstrip the growth in revenue throughout the first nine months of 2012.

Consequently the company sustained a 13.3% decline of its operating profit in the first nine months of 2012 compared to the year-ago period. Operating profit for 9M2012 came in at EUR628 million, down from EUR728 million a year earlier.

This equals an adjusted operating margin of 3.1% for 9M2012 and this is 0.7ppts worse compared to last year. In commenting on the Group's performance for the first nine months of 2012, Mr Franz said the results were "quite respectable and represent a solid and stable performance; all the more so given the challenging framework conditions in our industry" but they are "not sufficient" to secure the future of the company in the long term.

"We must therefore change our company. The current crisis has a quality of its own; it is a structural crisis and therefore requires structural change," Mr Franz said, stressing the Group will take actions that will go beyond those already planned under the SCORE cost savings and restructuring programme to lift the airline's profit levels.

As part of the SCORE package, which was launched at the beginning of 2012, Lufthansa Group wants to improve its operating result compared with 2011 by at least EUR1.5 billion by the end of 2014. SCORE includes the transfer of Lufthansa Passenger Airline's European non-hub traffic to its LCC Germanwings on 01-Jan-2013 as well as the reduction of 3,500 full-time jobs in administrative departments worldwide.

On net profit level, Lufthansa Group reported a 64.6% improvement in the first nine months of 2012 compared with last year. Bottom line net profit was EUR474 million for the period but this positive development is mainly due to the sale of bmi.

The former UK subsidiary, which was sold to British Airways parent International Airlines Group (IAG) in Apr-2012, burdened 9M2011 earnings with a loss of EUR143 million. In 9M2012 the bmi sale resulted in earnings of EUR36 million, mostly as a result of valuation effects.

Lufthansa Group select financial figures: 9M2012 vs 9M2011

Lufthansa Passenger Airlines' unsatisfactory profit situation will become worse

The company benefitted from its integrated aviation group approach, and its services segments - MRO, IT services and catering - once again bolstered the Group's earnings for the period, with their contribution to the operating profit and EBITDA increasing year-over-year during 9M2012.

Conversely, Lufthansa Group's passenger airline segment sustained a 2.5% fall in operating profit in 9M2012 to EUR345 million despite recording a 7% increase in revenue. Both its longstanding star performer SWISS and Lufthansa passenger airlines (Lufthansa and Germanwings) posted a fall in operating profit.

Lufthansa Passenger Airlines is the Group's largest single company and it only earned an operating profit of EUR64 million in 9M2012. This is less than half of the year-ago period's already meagre figure of EUR138 million and it is less than its much smaller sister airline companies, SWISS and Austrian Airlines.

During the 3Q2012 results presentation to analysts on 31-Oct-2012, Group CFO Simone Menne asserted that the "trend is particularly worrying because this company, which is so vital for the entire Group, only reached break-even in September towards the end of the peak season".

Mrs Menne confirmed that the Group had abandoned the target of an operating profit for the full year for Lufthansa Passenger Airlines and it is now expecting a "noticeable operating loss" in light of the high fuel prices and a weakened outlook for bookings for the winter season. "We have to expect that the already unsatisfactory profit situation at Lufthansa Passenger Airlines will become even worse," Mrs Menne conceded.

"Today, their margin is well below of those in the other Group companies. Let me say quite clearly, that we cannot tolerate this earnings level on a sustainable basis. It is the core segment for which most of our capital is being spent. And yes, we can see the improvements in the fleet's efficiency and in customer satisfaction. However, a margin - as low as this - is certainly not enough to finance the investments sustainably."

SWISS also saw operating profit fall, by about 33% to EUR163 million despite increasing revenue to EUR3.2 billion for the first nine month of 2012. In addition to fuel costs, the strong Swiss franc had an adverse effect.

Austrian Airlines benefited from its restructuring endeavours implemented by CEO Jaan Albrecht and the company's 9M2012 operating profit of EUR73 million beats last year's by EUR107 million when it was still showing red ink. The noteworthy reversal of its operating result came largely from the positive one-off effect of the transfer of flight operations to Tyrolean Airways, but even adjusted for this positive one-off effect Austrian Airlines achieved an operating profit of EUR5 million.

Lufthansa Group financial highlights by business unit: 9M2012 vs 9M2011

Revenue growth supported mainly by currency effects

In the first three quarters of 2012, the Lufthansa Group's revenue totalled EUR22.8 billion - an increase of 6.1% over the same period last year. Traffic revenue improved by 5.4% to EUR18.8 billion, of which the Passenger Airline Group accounted for EUR16.5 billion and Lufthansa Cargo (Logistics segment) for EUR2 billion.

Lufthansa Cargo recorded a 9.7% year-on-year decrease of revenue during in 9M2012 and the transport of freight and mail fell by 7.3% to 1.5 million tonnes. Ms Menne said the Group does no longer expect demand on the air cargo market to recover before mid-2013 and Lufthansa Cargo will therefore pursue its course of tight and flexible capacity adjustments.

The Passenger Airline Group increased revenue by 7.5% it the first nine months of 2012, with passenger numbers rising 3.5% on a 1.8% increase of capacity in terms of ASKs.

Higher volumes accounted for 2% of the traffic revenue increase and exchange rate effects accounted for 3.1% of the increase. Prices (including surcharges for fuel and air traffic tax) contributed to a slight rise of 0.3%, or EUR58 million in absolute terms. In absolute terms, higher passenger numbers contributed EUR351 million to the Group's revenue increase whereas exchange rate movements had a markedly stronger impact with EUR558 million.

Lufthansa Group revenue growth drivers, 9M2012 vs 9M2011

Oil price and currency drive up costs

Operating expenses climbed by a total of EUR1.2 billion (+ 5.6%) to EUR23.7 billion in 9M2012. The main factor behind this increase was the cost of materials and services, which went up by 9.3%. As in the first half-year of 2012, the increase stemmed above all from the EUR972 million (+21.2%) leap in fuel costs to EUR 5.6 billion resulting from the 12.3% increase in fuel prices after hedging, while the upwards trend of the USD dollar also added 10%.

In presenting the 9M2012 results, Mrs Menne told analysts that the effect of the Group's rolling hedge system has diminished owing to the fact that oil prices remained on a high level. In the first nine months of 2012 hedges only shortened fuel costs by EUR154 million, exactly the same amount as in 9M2011.

On the other hand, the Group operated about 1% fewer flights in 9M2012 as part of its tight capacity management and the use of larger aircraft. This combined with the phase-in of more modern aircraft reduced kerosene consumption and saved EUR49 million in fuel costs in the reporting period.

Fees and charges went up by 4.6% to EUR3.9 billion. The main drivers were a 10.4% increase in passenger fees, a 4.6% rise in take-off and landing fees and 3.9% higher air traffic control charges. Expenses from the air traffic tax went up by 4.2% to EUR274 million, partly due to the tax that has been levied in Austria since 01-Apr-2011.

When excluding fuel, the Group's operating expenses in 9M2012 rose only 1.5% year-over-year.

Lufthansa Group costs growth drivers: 9M2012 vs 9M2011

Traffic in Europe remains robust despite LCC pressure and euro zone worries

The airlines in the Lufthansa Group increased passenger numbers in 9H2012 by 3.5%, compared to the year-ago period, to 78.8 million. Passenger traffic rose 3.3% year-over-year to 157 billion RPKs on a more moderate 1.8% increase in capacity to 198.1 billion ASKs, improving group-wide load factor by 1.2 ppts to 79.3%.

Lufthansa Passenger Airlines, which now consolidates Germanwings, carried a total of 57.2 million passengers in the first nine months of FY2012 and RPKs were up 2.6% on a 1.6% increase in ASKs. The seat load factor rose accordingly on the prior-year level by 0.8ppt to 78.7%. SWISS transported around 12.9 million passengers in 9M2012, a 3.9% increase on the same period last year, and Austrian Airlines carried close to 8.8 million passengers.

The Group's passenger airline business segment succeeded in boosting revenue across all regions in 9M2012, with seat load factors and yields improving in all geographies.

Surprisingly, the highest passenger traffic growth in terms of RPKs was recorded in Europe, the Group's largest traffic region, where average yields (revenue per RPK) rose by 2.3% and traffic revenue grew by 7.3%.

Revenues increased particularly sharply in the Americas region, growing 11.2% year-over-year. With capacity remaining stable, this area saw the most marked improvement in its utilisation. Average yields increased by 8.6%. The Atlantic++ joint venture with United Airlines and Air Canada made a successful contribution to the positive performance in trans-Atlantic traffic.

The group's traffic revenues also grew 4.1% in the Asia-Pacific region and yields inched up 1.2%. Performance of this region is set to benefit from the new joint venture (Japan+) with All Nippon Airways (ANA), which was launched in 1H2012. Following approval by the Japanese competition authorities in Sep-2012, the plan is now to include SWISS and Austrian Airlines in this JV by mid 2013. Like Atlantic++, Japan+ entails the full integration of network planning, revenue management, pricing and distribution but with regard to the Europe-Japan traffic.

Yields and revenue increased in the Middle East, rising 3.7% and 4.9%, respectively.

Lufthansa Group's passenger airline segment passenger traffic growth per region: 9M2012 vs 9M2011

Full-Year outlook remains unchanged

For the full year Lufthansa Group is still forecasting increased revenue and an operating profit in the "mid three-figure million euro" range. This forecast does not include restructuring costs in connection with the SCORE programme and the planned reduction of jobs included in the cost-cutting scheme. These restructuring costs will not be more than EUR100 million in 2012.

In comparison to its European competitors, that makes Lufthansa Group one of the few major network airlines that are still recording profit. But Mr Franz is right that, in spite of this, the company's results, and particularly those of Lufthansa Passenger Airlines, do not suffice to remain competitive in the long run. The situation remains challenging for the Group, also given the economic environment with the ongoing crisis in the euro area and the persistently high fuel prices.

Top management has made it very clear, especially to employees, that it is steadfast in its target to put the company on a more lean and productive footing. Full implementation of its cost cutting and restructuring programme SCORE will be difficult but it is mandatory if Lufthansa wants to lead consolidation and remain one of the world's leading airline.

Background information

Top 20 airlines based on international capacity (seats per week): 05-Nov-2012 to 11-Nov-2012