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European airlines face overcapacity & resurgent labour. Recent profit warnings make alarm bells ring

A recent bout of profit warnings from a number of European airlines are ringing alarm bells and providing a reminder of the fragility of profitability in the industry. Airlines of different sizes, shapes and geographies have been prompted to announce a lower outlook for 2014 earnings, including Lufthansa, Finnair, Aer Lingus and Icelandair. Notably, these are all legacy carriers.

Although the details differ in each case, two broad themes emerge from these announcements. The first relates to signs of overcapacity in some markets, leading to revenue weakness. This is also linked with the growing competitive threat posed by alternative business models to Europe's legacy carriers, whether by LCCs on short-haul or Gulf carriers on long-haul.

The second theme is the impact that labour has on profitability, whether damaging it through industrial action, or assisting it through cost savings.

Lufthansa: revenue weakness, strikes, Gulf airlines

Lufthansa attributed its lower earnings forecast to weaker than expected revenues in the passenger and cargo business. In particular, it said that excess capacity was putting pressure on prices on European and American routes.

Lufthansa also blamed the pilots' strike in early Apr-2014, saying that this had cost it EUR60 million in lost traffic and bookings. Finally, the Venezuelan currency devaluation had also cost EUR60 million.

The Group's chief officer finances and aviation services, Simone Menne, said that strong capacity growth by state-owned Gulf carriers was a major concern, adding that they are "advancing ever further into the European market, also by means of investments in European airlines". Lufthansa intends to lower its capacity in the winter schedule relative to its previous plans.

Finnair: unit revenue weakness increases the need for labour-related cost savings

Finnair also sees a weakening revenue environment. It previously expected revenue this year would be close to 2013's level, but, on 2-Jun-2014, it said that it now expects 2014 revenue will be "significantly lower" than last year, since unit revenues have been weaker than expected. It made reference to the uncertain economic outlook in Europe and Asia, which it said was contributing to weak consumer demand.

In spite of expected growth in air traffic, the weakness of unit revenues meant that Finnair does not expect to benefit from that growth without further cost savings. Key to this is negotiations with employees over cost reduction.

Talks with the pilots were extended beyond the original deadline of 13-Jun-2014 and Finnair promised up to two years protection against lay-offs if agreement could be reached over how to achieved its EUR17 million savings target. Talks have been further extended to Sep-2014 after a partial solution, involving pilots' transferring to a new wage model and changes regarding new pilots, was reached in mid Jun-2014.

More time is needed to finalise the details of the new wage model, which will involve increased productivity. Finnair COO Ville Iho said: "The aim of the savings agreement is to enable Finnair's growth and ensure that we can handle growth with our own crew".

Finnair's Plan B for cabin services

However, talks with cabin crew over a EUR18 million savings target failed to reach agreement and Finnair is now moving ahead with its 'Plan B' to increase the outsourcing of cabin services. This will see cabin crew outsourcing on around 20 routes over two years, with one to three routes completed in 2014. Finnair aims to reduce its own personnel by the equivalent of around 540 man-years through a combination of redundancy, part time work and temporary lay-offs, with further details yet to be determined.

The cabin crew union proposed savings of EUR2.9 million immediately plus EUR4.8 million to be achieved within 20 years and EUR4 million of temporary savings for one year. Finnair's proposal was to implement EUR12 million of immediate savings and the remaining EUR6 million phased over time, but "even this compromise did not lead to an agreement", according to Mr Iho.

Aer Lingus: forward bookings hit by threatened industrial action

When it reported its 1Q2014 results on 20-May-2014, Aer Lingus still expected 2014 operating profit would be in line with 2013, in spite of a strike planned by members of the Impact union for early Jun-2014. Passenger traffic and retail sales had all performed strongly in Apr-2014.

However, the threat of an additional planned strike called for 16 and 18-Jun-2014 caused "significant damage to Aer Lingus' trading and forward bookings for several months into the future", according to a trading update issued by the airline on 12-Jun-2014. Although this second strike was deferred by the union, the impact on bookings led Aer Lingus to revise its expected 2014 operating profit down to between 10% and 20% lower than last year.

Icelandair: revenues hit by strike action

Icelandair recently lowered its 2014 EBITDA forecast modestly, from a range of USD140-145 million to USD138-143 million. The main reason for the reduced outlook is industrial action by maintenance workers on 16-Jun-2014, which has had an adverse impact on expected revenues. Higher salary costs are also a contributory factor.

The growth of Gulf carriers, and Turkish Airlines, in Europe

The first broad theme that is raised by these profit warnings is an excess of capacity. Lufthansa particularly noticed this on American and European routes. Before looking at the capacity situation in these regions, we first turn to Lufthansa's comments about the growth of Gulf carriers into Europe.

Data from OAG suggest that the combined seat capacity of the three Gulf carriers and Turkish Airlines from their hubs into Europe will grow at a slower rate in 2014 than in 2013 (see table below). However, their growth remains strong and their coverage of secondary European markets has taken share away from the likes of Lufthansa, although this is not a new issue. Lufthansa seems to have developed a reflex of blaming the Gulf carriers when things are becoming more difficult.

See related report: Etihad raises its Europe profile with codeshares and equity, expanding indirect connections

The Gulf Three and Turkish Airlines: year on year growth in weekly international seats from their respective hubs* to Europe: Jun-2012 to Dec-2014

 

Jun-13

Dec-13

Jun-14

Dec-14

Turkish Airlines

14.7%

16.8%

7.6%

7.7%

Emirates

17.9%

7.1%

-1.8%

13.7%

Qatar Airways

13.7%

19.1%

10.4%

12.6%

Etihad

17.3%

14.2%

9.2%

21.5%

Total

15.8%

13.4%

5.0%

11.7%

North Atlantic overcapacity?

Data from the Association of European Airlines lend some support to the assertion that the North Atlantic market may have moved into a modest overcapacity situation.

In the first six months of 2013, ASK growth on the North Atlantic for AEA member airlines was 2.7% and passenger load factor was 83.7%. In the period from the beginning of Jan-2014 to 16-Jun-2014, AEA capacity growth on the North Atlantic accelerated to 5.9%, higher than long term trend rates of demand growth, and load factor slipped by 1 ppt to 82.7%.

North Atlantic: growth in capacity by members of the Association of European Airlines

 

ASK growth

Load factor

Jan-Dec 2013

3.4%

85.2

Jan-Jun 2013

2.7%

83.7

YTD* 2014

5.9%

82.7

The AEA's weekly traffic data, up to the week commencing 9-Jun-2014, show that the 52 week moving average for ASK growth on the North Atlantic has been above 5% since mid-Feb-2014 and is higher than at any time for more than two years. The 52 week moving average for AEA load factor on the North Atlantic climbed from late 2011 until mid 2013 and then plateaued at a little more than 85%, but has fallen very slightly over the past couple of months.

Moreover, for the peak summer month of Aug-2014, seat growth between Western Europe and the United States will be 8.2%. This is a significant acceleration compared with Aug-2013, when growth was 5.5% compared with Aug-2012 (source: CAPA/OAG).

North Atlantic: growth in weekly ASKs for members of the Association of European Airlines: Jan-2010 to Jun-2014

North Atlantic: weekly load factor for members of the Association of European Airlines: Jan-2010 to Jun-2014

All this gives some support to Lufthansa's suggestion of overcapacity on the Atlantic, but it does not seem to be in any way severe. Moreover, the dominance of the immunised joint ventures on the North Atlantic has helped to curb excess capacity in this market in recent times, to the benefit of all players, and is probably still mitigating the impact on unit revenues of the current modest overcapacity situation.

The Star Alliance accounts for 33% of all seat capacity between Europe and North America, while SkyTeam and oneworld each have a 25% share (week of 23-Jun-2014, source: OAG). In addition, Virgin Atlantic's capacity added to that of JV partner Delta between the UK and North America accounts for 7% of seats on the North Atlantic.

Europe-to-Asia is more balanced

Europe's other major long-haul route region, to the Far East/Australasia, has also seen a rising trend of ASK growth. Nevertheless, the 52 week moving average has remained below 5% and the 52 week moving average load factor has remained steadily at or above 82% since Aug-2013. This suggests a more even balance of supply and demand on Europe-Far East/Australasia routes.

Europe to Far East/Australasia: growth in weekly ASKs for members of the Association of European Airlines: Jan-2010 to Jun-2014

Europe to Far East/Australasia: weekly load factor for members of the Association of European Airlines: Jan-2010 to Jun-2014

Routes within Europe are still seeing rising load factor trend, but LCCs contribute to price pressure

Lufthansa also pointed to routes within Europe as suffering from overcapacity. SAS also recently said that there had been an excess of capacity growth in its short-haul markets.

See related report: SAS yield decline outweighs cost cuts to give wider losses in 2Q. Market share versus profitability?

Within Europe, AEA data do not provide any clear evidence to support this. ASK growth on cross-border European routes has been on a slightly rising trend since the start of the year, when the 52 week moving average was 2.0%, but, at 2.8% for the week of 9-Jun-2014, this moving average remains below 3%. Moreover, according to the AEA data, the 52 week average for load factor on cross-border Europe has been on a rising trend for at least three and a half years (although the rate of increase is slowing).

Cross-border Europe: growth (%) in weekly ASKs for members of the Association of European Airlines: Jan-2010 to Jun-2014

Cross-border Europe: weekly load factor for members of the Association of European Airlines: Jan-2010 to Jun-2014

Of course, AEA data do not include low-cost carriers, who have been growing at faster rates on the whole. The modest growth of AEA members, the legacy carriers, has been at the expense of weaker pricing and this is what has contributed to Lufthansa's comments.

Labour disputes were a second common theme in recent profit warnings

Labour-related challenges can often increase in a cyclical upswing as the existential threat to airlines that is strongly felt in a downturn starts to fade and unions become more emboldened.

The growing importance of labour-related issues, including labour disputes, affecting European airlines was the subject of a CAPA Analysis report in Apr-2014. As we concluded then, it pays to be tough and this often means having an alternative to what can often end up as a deadlock in negotiations. Finnair is now pursuing its alternative with regard to cabin services (see above).

See related report: Lufthansa pilot strike highlights labour issues for Europe's legacy carriers. It's time to wake up

Focus must be on cost and capacity discipline

Although the recent spate of European airline profit warnings may not represent the entire industry in Europe, and profits for many airlines (Lufthansa included) are still expected to be higher in 2014 than in 2013, it is worth putting them into the wider industry context.

The most recent IATA financial forecast for the global airline sector, issued in early Jun-2014, was lower than its previous forecast, although 2014 is still forecast to have higher margins than 2013.

Five years on from the trough of 2009, it is important to remember that this remains a cyclical industry with fragile profitability. It usually does not take much by way of a catalyst to spark a cyclical downswing, be it overcapacity in certain markets, labour looking for an increased share of industry profits, or geopolitical events causing demand to slow. With oil prices now stretching the limits again, the cumulative stress guarantees continuing fragility.

In such an industry, the focus must remain on cost and capacity discipline.

See related report: Airline consolidation: could Europe follow North America's path to improved margins?

 

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