Cargo the Bright Spot in Lufthansa’s Dark Night

Madhu Unnikrishnan

August 9th, 2020

  • Europe, unlike the U.S., is getting the shorthaul summertime travel boom that airlines hoped for. It’s not really a boom of course, just a murmur of life after several months of nothingness. Carriers are filling planes though — Lufthansa said its shorthaul flights were 70% full last month, with decent yields to boot. Already by the end of this quarter, the airline will have restored service to 90% of its destinations within Europe, albeit with greatly reduced frequency and seat counts.

    The shorthaul recovery remains challenged by existing travel restrictions, sudden changes in travel restrictions, a recent uptick in Covid cases throughout Europe, and severe economic contraction. But a decent number of beach-bound sunseekers from Germany and elsewhere are indeed flying again. Good news? Yes, but not all that significant for an airline like Lufthansa, which unlike its U.S. Big Three counterparts, derives just a modest percentage of its revenues from shorthaul.

    As long as longhaul markets remain largely closed—and they might be for a long time—Lufthansa faces grim times ahead. It does have another area of strength right now, one far more significant. As a leading player in the cargo space, it’s greatly benefitting from surging demand for items like medical supplies, coupled with a worldwide capacity shortage, leading to a doubling of Q2 cargo yields. That enabled Lufthansa’s cargo business to earn a $332m operating profit in the quarter, equating to a mammoth 39% operating margin. Cargo accounted for 40% of the group’s Q2 revenue. Nevertheless, it wasn’t nearly enough to offset the multi-billion-dollar losses incurred by all of its other businesses. Lufthansa’s large maintenance business accounted for much of the group’s other revenue. But with airline customers around the world grounding so many planes, maintenance was a money-losing affair to the order of negative 18% in terms of Q2 operating margin.

    The group’s passenger airlines meanwhile—Lufthansa mainline, Swiss, Austrian, Brussels Airlines, and Eurowings—collectively amassed $1.9b in operating losses. All added up, groupwide operating margin for the period was negative 89%, one of the least bad figures worldwide thanks to the cargo cushion. Passenger flight activity was minimal in the quarter, picking up on shorthaul routes only in June. As CEO Carsten Spohr explained, the crisis is overturning many of the basic tenets of airline economics, including the principle that passenger flights make money when optimized for passenger demand; cargo is a secondary consideration. Now, especially with fuel so cheap, some of Lufthansa’s passenger flights are making money with zero passengers on board, thanks to the cargo. So cargo becomes a primary consideration.

    Another change is the idea that fuel prices matter much more for route planning purposes than airport costs. That principle too is now reversed. In Lufthansa’s case, most of its major hubs, including Zurich, Vienna, and Brussels, have lowered their fees and charges to help their airline tenants. Munich will likely do the same. But not Frankfurt, to Lufthansa’s obvious frustration. Frankfurt is actually increasing charges. And that happens to be Lufthansa’s largest hub for both passengers and cargo.

    In any case, no amount of cargo riches would have been enough to avert a quick evaporation of cash, particularly with billions in customer refund requests outstanding. The group in fact burned through something like $1.8b in cash during Q2, equivalent to about $20m every day. Even with a strong balance sheet entering the crisis, there was no way around it. Lufthansa needed government aid. What it got was a $10m package, supported by not just Germany but also Switzerland, Austria, and Belgium. The terms are onerous though: heavy debt repayment obligations and a 20% ownership stake for Germany’s government. Said Carsten Spohr: “This is not a gift.” Refinancing and repaying the money will be one of Lufthansa’s highest priorities in the years ahead, restoring the company to full private-sector ownership.

    It’s quick to remind analysts, however, that Air France/KLM too is partly state owned. So are key competitors Turkish Airlines, Singapore Airlines, and even IAG, which is turning to Qatar’s state-owned airline for new equity. To get itself back to a point where it can start repaying its bailout proceeds, Lufthansa will of course need to see more substantial demand recovery, including longhaul market recovery. That in turn can only happen once governments start relaxing travel restrictions. But full recovery to 2019 traffic levels won’t happen until 2023, according to management’s best guess.

    Even when that happens, Lufthansa expects to be 100 planes smaller than it was pre-crisis, which means major productivity gains are essential. Much of that, unfortunately, will need to come from a smaller workforce working under more flexible contracts. Management already has a $555m cost-saving deal with its German flight attendant union, subject to ratification later this month. Deals are also in place with unions at Austrian and Brussels Airlines. But negotiations with pilots and ground workers in Germany aren’t going smoothly, meaning involuntary layoffs are coming. Along with its job reductions (22k in all) and fleet reductions, Lufthansa is shrinking its management team, proceeding with a sale of its European catering operations, and considering longterm options (a partial IPO or strategic partnership, perhaps) for its giant maintenance unit. It closed some operating units like Sun Express Germany and Germanwings (part of Eurowings) in a bid to reduce its number of airline operating certificates (AOCs) to ten. Raising some eyebrows among investors, it’s creating a new operation for low-cost longhaul flying dubbed Ocean. But management assures this won’t be a separate brand, just an internal name for an initiative to consolidate its l4-plane longhaul leisure flying into one AOC rather than three currently (Sun Express, Brussels Airlines, and CityLine, the latter originally a regional operation). It’s not yet decided whether Ocean will use a new AOC or one of the old ones.

    At mainline Lufthansa, A380s and B747s are history. Some A320s will leave forever as well. Grounded A340-600s might come back but certainly not for another year at least. Austrian is shedding B767s and some turboprops. Future deliveries will slow (the last thing it needs right now are those B777-9s it ordered). Fleet standardization and densification is a consideration. It’s all part of what the group calls its ReNew recovery plan. Leisure units Eurowings and Edelweiss will indeed play an important role in near-term recovery, with business and corporate demand expected to revive more slowly.

    Uncomfortably, Lufthansa relied heavily on premium intercontinental corporate demand, more so than almost any other airline, save perhaps Singapore Airlines. As it closely watches Covid vaccine and treatment developments, it’s surely also keeping an eye on competitive developments, including any inclinations for German rivals Condor and TUIfly to cooperate. By the end of October, Lufthansa hopes to have about half its fleet back in the air, operating about 40% of pre-crisis ASK capacity. Brussels, for one, has plans to offer a shorthaul product and fare offering more consistent with mainline Lufthansa.

    Groupwide joint ventures with United, Air Canada, All Nippon, Singapore Airlines, and Air China will remain important. Value, much more so than growth, will be a new groupwide emphasis. Cash burn should stop in early 2021 assuming travel restrictions ease. Cargo certainly helps on the cash front, as does the successful shorthaul flight restoration that began in June. A lift in oil prices since April counterintuitively helps cash burn too, because it reduces obligations tied to its wrong-way hedges.

    No, it’s not a pretty picture. But once Lufthansa gets through the nightmare of 2020, and the likely difficulties of 2021 and 2022, it will reassess its fleet plans and other aspects of business.   
  • On April 7, Japan’s national government declared a state of emergency in response to the Covid pandemic, strongly discouraging air travel. Only on June 19—late in the calendar second quarter, in other words—were restrictions on inter-prefecture domestic travel removed. International flight activity remained all but dormant during the quarter. And only with a 17% y/y increase in cargo revenue did Japan Airlines—the nation’s second-largest carrier—limit its calendar Q2 revenue decline to 78%.

    Cargo in fact generated 55% of JAL’s transport revenue last quarter, up from just 8% in the same quarter a year ago. The increase came from semiconductor exports to the U.S., Japanese imports of fresh food from Europe, medical supplies from China to Europe and Japan, electronics exports from Asia to North America and Japan, and a jump in domestic e-commerce. On the expense side, costs associated with operations dropped only 38%, far less than that 78% revenue drop. As a result, losses were heavy, reaching $871m at the net level. Operating margin was negative 170%.

    A week earlier, rival All Nippon reported a negative 131% operating margin, with similar revenue and capacity declines. ANA saw a bigger drop in fuel costs, however, accounting for the somewhat better performance, though the comparisons aren’t all the meaningful. Both carriers face the same problem: collapsing demand in the context of a global pandemic. And pre-crisis, both derived about half of their passenger revenues from domestic markets and the other half from international (historically, JAL has been much more international than ANA).

    This fiscal year, which for JAL started in April and will end in March 2021, revenues are expected to be roughly 35% to 45% what they were in the prior fiscal. The airline is of course cutting costs, highlighting labor and aircraft as its two major fixed costs items. Fuel, landing and navigation fees, maintenance, sales commissions, and customer service by contrast are largely variable. JAL also has a large travel agency business, as well as other businesses involved in ground handling and credit cards, for example. On the all-important liquidity front, JAL was able to raise nearly $5b via bond issuance, bank loans and sale-leaseback deals. It has another nearly $2b to tap from an unused credit line. It burned through roughly $15m a day on average during the quarter. But cash burn is easing as ticket refund requests slow, and as domestic demand gradually recovers. JAL fortunately entered the crisis with a strong balance sheet, which has been a hallmark of its business since restructuring in bankruptcy a decade ago.

    For much of the 2010s, JAL was one of the world’s most profitable intercontinental airlines (its operating margin last year was 10%). This summer, the carrier is seeing more of what it calls “urgent” demand, as well as a revival in some domestic leisure travel, boosted by government incentives. Covid cases in Japan, however, have jumped in recent weeks. Internationally, demand is still driven mostly by expatriates returning home, with cargo demand also a major factor influencing where passenger flights are restored. Future restorations will depend on the relaxation of international travel restrictions. Japanese airlines are getting modest government support, mostly in the form of tax and fee deferrals or waivers.

    Looking beyond the crisis, JAL has its new LCC Zip Air ready to go, flying just cargo for now but eyeing passenger service to Bangkok, Seoul, and Honolulu. A joint venture with Hawaiian Airlines failed to win U.S. regulatory approval, but partnerships remain a strategic focus. That includes a newly formed joint venture with fellow oneworld member Malaysia Airlines. IAG, Finnair, China Eastern, and American are other key partners. It wants to partner with LCCs as well. Another strategic initiative is winning more sixth-freedom traffic between North America and the ASEAN region via Tokyo.

    International expansion opportunities, however, which looked set to get a boost this year with new planes, new Tokyo Haneda airport slots, and the Tokyo Olympics, are now more muted. JAL in fact is talking with Boeing and Airbus about deferring aircraft deliveries (B787s and A350s). In addition, it will retire some older B777s earlier than planned. Sometime before its current fiscal year ends (March 2021), JAL will update its business plan with more specific initiatives.

Meanwhile, Cargo Drives Korean and Asiana to Profits

  • Hold the phone! Stop the presses! There’s a passenger airline, believe it or not—two of them actually—that earned second quarter profits. Korean Air and Asiana, both based in Seoul, earned operating margins of 9% and 14%, respectively, despite y/y revenue declines of 44% and 45%. Their net profits were $133m and $95m, though that included some forex gains that masked heavy interest expenses. Like other airlines, Korea’s Big Two saw near-total destruction of passenger demand as the Covid pandemic closed borders. But both get a large percentage of revenues from cargo even in normal times, in Korean Air’s case 21% of total revenues last year. And that was lower than usual because of trade wars and other adverse developments. In Q2, by contrast, Korean Air enjoyed a 95% y/y increase in cargo revenues, aided by the conversion of passenger planes to all-cargo vessels. The strongest cargo gains were on North American routes, which justified flying more passengers to the region.

    International passenger demand though, was largely limited to Korean nationals returning home, or foreign nationals returning home from Korea.  Thanks to an effective public health response to Covid, Koreans are taking vacations again, but only domestic vacations. Jeju, the island resort, is seeing a nice revival. But domestic markets, even when totally healthy, are a mere fraction of Korean Air’s business. Same for Asiana. Both have premium-centric business models replete with large premium class sections plump with amenities. Both unwisely ordered A380s. Both, incidentally, had miserable balance sheets as they entered the crisis, Asiana especially. But both are downsizing their premium cabins and have been for some time, even before the pandemic. Both are building large fleets of more efficient widebodies planes, like B787s for Korean Air and A350s for Asiana. Both have LCC platforms to use as they chase the expected near-term revival in leisure and family-visit demand. Both received government financial assistance early in the crisis.

    Korean Air was lucky to sell a big stake to Delta before the crisis, and before a battle for management control that pitted one group of founding family members versus another (Remember the “nut rage” lady? She was on one of the sides). Asiana struck a deal to obtain a new controlling investor, but it’s not yet finalized and looking more and more like it won’t be.

    A third Korean carrier by the way, Jeju Air, also reported Q2 results last week but no, it did not earn a profit. As a shorthaul LCC flying only B737s, it lacked a cargo cushion. Instead, it stumbled to a negative 235% operating margin. Like Hyundai Construction, the investor getting cold feet about buying Asiana, Jeju itself got cold feet about a deal to buy rival EastarJet. That spells likely doom for Eastar, and a smaller post-pandemic universe of Korean airlines.   
  • Indonesia’s Garuda published its Q2 results, which showed a $510m net loss excluding special items, with a negative 368% operating margin. Revenues fell 86% y/y on 82% less ASK capacity. Unimpressively, operating costs declined only 34%. The airline didn’t disclose results for its LCC Citilink, a mostly domestic operator until taking some A330-900 NEOs. Citilink overall dropped its ASK capacity 67% in the quarter, maintaining some domestic services.

    The resort island of Bali, in fact, is now reopened for tourism. But a nascent domestic recovery isn’t enough to offset the losses of much larger markets like religious pilgrimage travel to Saudi Arabia. Singapore and China are other important markets. Mercifully right now, Garuda doesn’t fly to the Americas, showing its flag there only through its membership in the SkyTeam alliance. It has a handful of European routes including Amsterdam, underpinned by business and family links dating back to Dutch colonial rule of Indonesia.

    How about Garuda’s cargo business? Don’t think Korean Air or Asiana-type scale. But it typically gets about 9% of total revenues from cargo, which indeed helped as freight markets boomed last quarter—cargo was 51% of Q2 revenues. Still, Garuda is a financial mess, requiring government assistance. More is needed as the airline misses payments to creditors and burns through cash flying its limited schedule.
  • For the first time in two decades, Panama’s Copa suffered a quarterly loss excluding special items. All the many strengths that typically make it among the world most profitable airlines—its excellent hub, for example—matter little when it’s not allowed to fly. Without any domestic routes, aside from some within Colombia operated by its LCC Wingo, Copa’s operations were almost entirely mothballed through the entirety of Q2. It managed just $15m in revenue, effectively a 100% reduction from last year’s total. With $123m in unavoidable costs, operating margin was negative 748%.

    But that’s just for the records. The point is, Copa can’t generate revenue unless it’s flying, but still has fixed costs even when not flying. Its largest cost item in Q2 was actually depreciation, a non-cash accounting cost. The grim situation—all planes have been grounded since March 21—will start to change when Panama starts allowing what Copa is calling “humanitarian” flights this month. That will involve 10 destinations, including key markets like Miami. Then, assuming no further pushbacks, Copa will be allowed to resume regularly scheduled service on Sept. 4. Even so, it will be flying less than 10% of its normal schedule. I

    n the meantime, Copa is preparing for a meaner, leaner, and ideally greener future by putting its remaining B737-700s up for sale. It’s already contracted to sell its E190 fleet. Which will leave it with just B737-800s and B737 MAX 9s, many of the latter still on order. Planes not in use will be kept in longterm storage for readiness when needed. The best guess is for capacity to reach 30% to 40% of normal levels by yearend. Thankfully, liquidity is in sufficient supply following convertible bond sales and other fundraising steps to build upon a strong pre-crisis balance sheet.

    One important question looking ahead is whether bankrupt competitors Latam, Aeromexico, and most importantly Avianca will be weaker or stronger post-crisis. They’ll be smaller for sure, but also sport lower costs. One can’t help but remember the example of American in the U.S., which for years avoided bankruptcy, only to watch bankrupt rivals become significantly more productive and efficient. American was never as strong as Copa though.

    Longterm, the Panamanian airline still thinks the strategic location of its hub will be a major advantage linking north, south, and central America, including the Caribbean region. Of course, longer-range narrowbodies like NEO LRs and XLRs could obviate the need for hub connections on more north-south routes within the Americas. But many of Copa’s top origin-destination markets are too small to serve without a hub—think of someone flying from Chicago to Santiago, or Denver to Brasilia. Chicago and Denver happen to be hubs for United, a longtime close ally of Copa’s. In fact, the two were prepared to join with Avianca on a three-way joint venture before intervening events (even before the crisis, Avianca’s pre-bankruptcy restructuring got in the way).

    Asked during its Q2 earnings call about merging, Copa gave a boilerplate non-answer. Mergers though, might not make sense for a company that just last year earned a lofty 16% operating margin—why mess with success unless there’s a clear and present strategic threat? The airline certainly acknowledges that demand and yields will be weak for some time, and that its cash burn will persist even after its relaunch. 
  • Etihad’s not a publicly traded company. It’s 100% owned by Abu Dhabi’s government. But it nevertheless voluntarily disclosed a hideous $758m operating loss excluding special items for the six months to June. That was up from $586m for the same six months of 2019. It said the year started well, before Covid struck with a vengeance. It didn’t provide loss numbers for Q2 alone. But its 16% load factor for the period is evidence enough of the horrors. If there’s one bright light, it’s cargo, revenues for which jumped nearly 40% y/y in the half.

    About 70% of Etihad’s fleet was grounded last quarter. And planes that were flying did so less actively, such that total ASK capacity decreased 95%. It hopes to have about half of capacity back in action by next month. It began offering some limited connecting itineraries through Abu Dhabi in June. Making money was never Abu Dhabi’s chief goal for Etihad. And there’s no shame in that—there are far worse ways for a small city-state to spend its oil riches than on a labor-intensive, professionally-run enterprise creating lots of highly-skilled jobs. At some point though, the losses can grow intolerable, which became the case after an earlier string of buying blunders—Jet Airways, Virgin Australia, Air Berlin, and for heaven’s sake Alitalia. Not since Oscar the Grouch had anyone been so fond of junk. A subsequent mop-up job that included big cost and capacity cuts eased the pain somewhat.

    But Etihad now faces a world turned sick by Covid. A merger with Emirates is always in the background, occasionally rumored and frequently denied. In its own backyard, Abu Dhabi’s government is rolling the dice on low-cost airline development, partnering with Air Arabia and Wizz Air to create two new LCCs, never mind the impact on Etihad. Oh yeah, and oil prices are low, a deeply unsettling reality for many governments on the Arabian Peninsula.

Madhu Unnikrishnan

August 9th, 2020