Lufthansa Sees Forced Capacity Discipline

Edward Russell
October 31st, 2022 at 12:01 AM EDT

The capacity discipline foisted on the airline industry by the confluence of a myriad of constraints is not expected to dissipate anytime soon. But that’s good financial news, Lufthansa Group CEO Carsten Spohr said last week.

Global supply chain bottlenecks have slowed the delivery of new aircraft — including of Lufthansa’s own new Boeing 787s — staffing remains a limit on growth, and high fuel costs and other fees act as barriers to entry to new competitors, Spohr said during the group’s third-quarter earnings call. This will keep what airlines can fly next year in check, even if there is travel demand for more flights.

“Global aviation will not return to the overcapacities witnessed in the pre-pandemic times anywhere soon,” he said. Though Spohr added that the discipline was “forced” on the industry, rather than the result of more rational management and planning.

But even a disciplined recovery involves some big moves, including bringing back Lufthansa’s Airbus A380s. Three aircraft will resume flying at its Munich hub next June, with the number likely to increase in response to demand, Spohr said. “You should book now because our passengers love it and want to fly it,” he added jokingly to investors.

The Lufthansa Group sees continued strong travel demand even with the economic storm clouds. Lufthansa anticipates a 22-23 percent increase in yields in the fourth quarter compared to 2019, while flying roughly 15 percent less capacity, Chief Financial Officer Remco Steenbergen said. Yields increase nearly 23 percent in the September quarter.

“We don’t see any end of the high yields looking through [the fourth quarter],” Spohr said. “And, to take that into [the first quarter], why would it end? There is some optimism there.”

Spohr’s comments came despite a gloomy economic outlook. The International Monetary Fund lowered its growth forecast for the eurozone earlier in October to just 3.1 percent this year, and 0.5 percent in 2023 — an 0.8 and 2 point reduction, respectively, from its January outlook. Germany, along with Italy, is forecast to slip into a recession next year. The organization highlighted a “cost-of-living crisis” that includes both high inflation and energy prices.

Many other airlines, including those in the U.S. and Latin America, share Spohr’s bullish demand outlook.

One emerging opportunity is blended leisure and business travel. Spohr said that when he joined Lufthansa in 1994 the “strongest” day of the week for the airline was Friday. “Now it’s Thursday and Saturday, [and] that says a lot,” he said. That, he added, “offers new opportunities” for the group.

Costs remain a concern. Lufthansa expects fuel costs to remain elevated through next year, Steenbergen said. As such, the group continues to work on other areas of cost savings, including its €3.5 billion ($3.5 billion) in structural cost cuts by 2024. Inflation, however, has shifted some of those savings to different parts of Lufthansa’s business than originally planned, including its sales and maintenance functions. Labor costs are also a question mark; the group has reached 10 new accords, including with its pilots at Austrian Airlines, Lufthansa, and Swiss Air, but others, including with Eurowings pilots, remain outstanding.

Spohr was frank on negotiations with pilots at Eurowings, who have held three one-day strikes so far in October: “Additional costs result in less routes being profitable, result in less aircraft being needed unless you can lower the cost somehow else. That’s why five aircraft have been taken out.” He added that cost increases could “endanger the business model” of the group’s budget airline.

The Lufthansa Group expects fourth quarter unit costs excluding fuel and foreign exchange to increase at a rate lower than the 9.5 percent year-over-three-years rise in the September quarter.

In the third quarter, the group reported an operating profit of €1.1 billion, and a net profit of €809 million. Revenues came in at €10.1 billion, a 93 percent year-over-year increase and down just 1 percent from 2019. Passenger traffic and capacity were both down roughly 22 percent year-over-three-years.

Austrian was the group’s strongest margin performer in the third quarter. It posted a 16 percent operating margin and €110 million operating profit during the period. Steenbergen, who described the quarterly profit as a “record” for the airline, said the success was the result of yield growth outpacing costs at Austrian, and its “extremely good” brand and service position in the market compared to low-cost competition.

Looking ahead, the Lufthansa Group plans to fly roughly roughly 80 percent of its 2019 capacity in the fourth quarter, and maintains its guidance of roughly 75 percent for the full year. Executives reiterated their September guidance of a full year operating profit of more than €1 billion; more than double the expectation in July. The airline did not provide detailed financial guidance for the fourth quarter.

Edward Russell

Summer Transatlantic Demand Lifts IAG

International Airlines Group pleased investors last week with strong summertime profits that show no signs of fading this fall, even as macroeconomic and cost headwinds intensify. The carrier echoed many of the broad trends currently defining the airline industry, including strong travel demand and extremely strong pricing but also rising costs.

IAG produced a 16.5 percent operating margin for the peak summer quarter, down from 19.5 percent in the same quarter of 2019. Prior to the pandemic, the group had become one of the world’s most profitable airlines, a status it hopes to recapture now that the crisis has waned. That 16.5 percent figure was indeed among the best of all airlines reporting so far, and better than what Air France-KLM and the Lufthansa Group reported.

Key to full-year European airline success, however, is not merely making big profits in the summer but also avoiding big losses in the winter. Encouragingly for IAG, it’s guiding investors to expect a $400 million operating profit in the current October-to-December quarter, which would bring full-year profit to roughly $1.1 billion. For all of 2019, IAG’s operating profit was $3.7 billion — this year’s results will include the drag from earlier months, prior to the strong rebound in demand this summer.

In the fourth quarter, only Aer Lingus will be back to pre-Covid capacity levels. Other IAG airlines, namely British Airways, Iberia, Level, and Vueling, will still be flying less capacity. British Airways’ capacity will reach just 80 percent of 2019 levels, held down by London Heathrow’s capacity limitations and exposure to shuttered East Asian markets. British Airways is, however, restarting two key Asian routes — Hong Kong and Tokyo — with executives saying that the Hong Kong route is booking well.

Largely because of its Heathrow constraints and Asian exposure, British Airways was the worst performing of IAG’s four big airline brands in the third quarter, with an operating margin of 12 percent. Vueling, a highly seasonal airline that typically runs up its margins in the summer, came in at 25 percent. Aer Lingus, which is also highly seasonal, was 25 percent and Iberia 15 percent.

For IAG collectively, financial performance is heavily influenced by developments across the transatlantic. Rivals Air France-KLM and Lufthansa are major market players too but not nearly as dependent on it as IAG. That dependence is a plus right now, with both North Atlantic and South Atlantic markets extremely strong from a demand and revenue perspective. That’s even true from European points of sale, IAG executives said, despite what currency movements would suggest. Strength was evident for premium and non-premium segments. Management also affirmed what many other airlines have been saying this earnings season: That people are increasingly combining their business and leisure trips, a phenomenon facilitated by remote working and flexible office hours.

Supporting IAG’s results was strength in several key business units, most notably loyalty — including money earned from mileage sales to credit card partners — and BA Holidays. Cargo, though still producing much higher revenues than in 2019, accounted for just 5 percent of company revenues. The pandemic-era cargo bonanza, in any case, seems to be coming to an end. “Demand is beginning to soften and world trade has begun to lose momentum in the second half of 2022,” IAG CEO Luis Gallego said during the company’s third-quarter earnings call.

Also featured during the call were mentions of some key IAG marketing initiatives, including the rollout of new premium seats at British Airways and Iberia, their move into American Airlines’ terminal at New York JFK airport later this year, and the expansion of British Airways joint venture with Qatar Airways. Management separately said forward bookings look good for both longhaul and shorthaul routes, except for Asia which is still lagging. Premium leisure travel looks as good as it ever did, and business travel is recovering. Some labor questions remain outstanding, one being whether British Airways’ pilots will vote to approve a new tentative contract agreement.

Jay Shabat

Air France-KLM Eyes TAP Investment

Portugal is beckoning to Air France-KLM. A potential investment in state-owned TAP Air Portugal would complement its deal for Italy’s ITA Airways in several of Europe’s fastest recovering markets.

“We’re very comfortable with the Iberian peninsula, and TAP could be [an] option for us to have a larger presence,” Air France-KLM CEO Ben Smith said during its third-quarter earnings call last week. The group will “definitely engage” with the Portuguese government on a “formal basis” when it is ready to sell down its full ownership in TAP, he added.

An Air France-KLM and TAP deal would just be the latest in what is becoming something of an airline consolidation spree in southern Europe. The group is already part of the preferred bidding consortium selected by the Italian government to take over ITA; private equity firm Certares leads the bid. And IAG is working on a new structure for its proposed takeover of Spain’s Air Europa with an aim to close the deal by the end of 2023.

All these potential airline deals come as Europe’s budget carriers, from EasyJet to Ryanair and Wizz Air, are rapidly expanding in many of the same markets. This is fueled, in part, by slot divestitures that legacy airlines like Air France-KLM and TAP agreed to as conditions of the state Covid relief they received during the crisis.

The interest in southern Europe is at least two fold. For one, it’s the age old argument for consolidation: Larger airlines typically benefit from better economies of scale, for example when buying new planes, and improved pricing power in the market. However, regulators often push back against deals for some of the very same reason airlines want them: Improved pricing power often means higher ticket prices for travelers. That said, larger — and one hopes stronger — airline groups can also grow more, which benefits travelers.

And second, southern Europe has several large markets that are among the fastest to recover in Europe. Spain is the European Union’s second largest after Germany, and Italy its fourth. Passenger traffic in Portugal and Spain recovered to 96 percent and 80 percent, respectively, of 2019 levels in the first half of 2022, Eurostat data show. Comparatively, Germany and France only recovered to 61 percent and 73 percent, respectively, of pre-pandemic numbers. Data for Italy was not available for the period.

On the ITA acquisition, Smith said the consortium’s exclusivity period to finalize a deal with the Italian government expires at the end of October. He did not say more about what could happen if the deadline passed, or if Lufthansa could make a renewed push for the airline.

Air France-KLM also sees growth opportunities within its own airline portfolio. The focus is on its budget arm Transavia, particularly in France, that is in the process of taking over the bulk of the group’s operations at Paris’ Orly airport. Smith said the shift is “almost complete,” and added that, when finished, would allow the group to grow profitably at the airport while staying in line with French laws that bar most flights on routes where a train makes the journey in two-and-a-half hours or less.

Asked how the growth of Transavia translates into future growth for the group, Smith said the group would shift its focus to adding new point-to-point routes in Europe from second tier cities in France once the Orly transition was complete. While he did not name names, these would likely include Lyon, Nice, and Toulouse. This growth would act as a sort of “consolidation” by allowing the group to capture a larger share in these markets, Smith said.

Secondary French markets have proven a successful strategy for competitors. Spanish discounter Volotea opened bases in Lille and Lourdes this year, and Lyon in 2021, bringing its total bases to eight in France.

Air France-KLM reported a $1 billion operating profit, and a $457 million net profit during the September quarter. Revenues increased 5 percent year-over-three-years to $8 billion after a roughly $224 million hit from the operational issues airlines faced across Europe this summer. Corporate revenues recovered to 76 percent of 2019 levels in the third quarter. And yields were up 24 percent compared to 2019 with passenger capacity being down nearly 15 percent.

Looking ahead, Air France-KLM plans to fly roughly 85 percent of its 2019 capacity in the fourth quarter. Full year capacity will be down roughly 20 percent from three years ago. The group forecasts a roughly $894 million operating profit for the year.

Air France-KLM Chief Financial Officer Steven Zaat, when asked about 2023 capacity, said it would continue to recover towards 2019 levels but warned that the operational issues the industry faced this year would “probably not be totally over.”

Edward Russell

Q3 Round Up

After a spectacular spring quarter, typically its best of the year, Southwest Airlines came back to earth with a pedestrian third quarter operating margin of just 7 percent, a bit below what even American managed. This is doubly surprising because Southwest’s fuel hedges allowed it to pay just $3.39 per gallon last quarter, meaningfully cheaper than what others paid. In fact, Southwest saved $220 million from its hedges last quarter, with expectations of $1 billion in full-year savings. Demand is definitely not the problem. It was strong in the third quarter and remains strong in the fourth quarter. Southwest’s balance sheet strength is second to none. Less happily, non-fuel units are up 12 percent from their 2019 levels. Some of that pressure will ease as Southwest returns to more normal levels of productivity and efficiency, achievable when it fully restores its network (doing that requires more pilots). Other cost pressures will remain, specifically for labor and airports. “Given the level of first half capacity growth,” said Chief Financial Officer Tammy Romo, “in a pre-pandemic period, we would have expected CASM-ex [fuel] to be subtly down year over year. However, we expect to continue experiencing unprecedented cost headwinds due to higher-than-expected inflation.” Chief Commercial Officer Andrew Watterson, meanwhile, said: “I think we have a couple of years where demand and supply may not be as aligned as it was pre-pandemic, which I think will [mean] yield tailwinds for a while.” One big uncertainty for Southwest: Can Boeing deliver its Maxes on time, and when will the Federal Aviation Administration certify the -7 version?

JetBlue Airways underperformed its peers again, with just a 6 percent operating margin last quarter. Elevated unit costs remain a concern, as does an aviation ecosystem it calls “fragile.” That includes issues with air traffic control staffing, often having an outsized impact on core JetBlue markets like the congested northeast and Florida. Hurricanes in Florida and the Caribbean led to some disruptions and losses in the third quarter. Overall though, the carrier says its operations have greatly improved, and that its own staffing is now where it needs to be. It sees no sign of slowing demand. There’s certainly a lot going on strategically at JetBlue. Most dramatic is its takeover of Spirit Airlines, subject to regulatory approval. An alliance with American is being litigated by the Justice Department. JetBlue will soon announce more European flying to supplement London. JetBlue Products, a division that sells tour packages among other things, will earn $100 million in operating profits this year (it only earned $15 million in 2019). And management claims to be only in the “early innings of the multi-year evolution of our loyalty program.” (TrueBlue now generates 10 percent of company revenues, versus 7 percent pre-Covid). More Airbus A321neos will arrive configured with premium Mint cabins. Corporate business is returning. More than half of all customers are buying up to Blue and Blue Extra fares. Sounds promising. But JetBlue faces heavy cost headwinds, including a new pilot contract to negotiate, rising maintenance and airport costs, a fleet transition out of its Embraer E190s, and ultimately the integration of Spirit. It also faces delays getting new A220s and A321neos.

In the meantime, Spirit reported its third quarter results as well, earning a measly 1 percent operating margin. To be fair, the summer quarter isn’t a particularly good one for Florida, so underwhelming third quarter margins are perhaps forgivable. But during the same quarter in 2019, Spirit managed a nearly 14 percent operating margin. Florida’s air traffic control headaches were a drag, as were elevated employee attrition and an aircraft utilization rate of just 10.6 hours per day, down 15 percent from 2019. As every other airline says, demand remains strong. And Spirit’s utilization rates should normalize by mid-2023. 

In Brazil, Gol managed just a 1 percent third quarter operating margin, keeping in mind that the period is an offpeak season in South America. Still, the mere 1 percent figure underscores a difficult cost environment that’s offsetting a strong demand environment. Gol’s net result, by the way, was heavily in the red, weighed down by foreign exchange accounting. Helpfully, the Brazilian currency, though sharply weaker versus the dollar year-over-year, has more recently avoided the depreciation hitting most other world currencies. Gol is confident it can weather the challenges as more Boeing 737 Maxs arrive, develops new leisure routes to Miami and elsewhere, grows its Smiles loyalty program, pays more attention to cargo, tightens its cooperation with American, and joins forces in a corporate merger with Avianca.

In Mexico, Volaris joined Aeromexico in reporting a third quarter profit. But its operating margin was just 5 percent, compared to Aeromexico’s 9 percent. Both carriers, counterintuitively, are benefitting financially from the downgrade of Mexico’s aviation safety rating by the FAA — this curtails Mexican airline expansion to U.S. markets, lifting average fares. Mexico City’s stricter airport slot controls have the same effect, though this benefits Aeromexico more. And Volaris, to be sure, is eager to expand its U.S. flying, hoping the FAA upgrades Mexico’s rating next year. Separately, Volaris insists it faces no staff shortages (including pilots). Bookings, it said, remain “solid,” and markets remain “quite rational and stable,” especially now that Interjet is gone and Aeromexico is focused on the premium market. That said, a new threat could emerge as Mexico moves to open its domestic airline market to foreign competitors. For Volaris, non-ticket revenue accounted for 41 percent of third quarter revenues, never mind new regulations limiting bag fee charges. Nearly half its routes face no nonstop airline competition — just busses. Key to lowering unit costs will be newly arriving Airbus A320neos. Volaris will have more to say when it hosts an investor day event in December.

Back in Europe, recently restructured Norwegian Air had a good third quarter. It posted a 15 percent operating margin on revenues of 7.1 billion Norwegian kroner ($689 million). Unit revenues increased 61 percent and unit costs excluding fuel decreased 25 percent year-over-year; and, compared to 2019, the former was up 85 percent and the latter 39 percent. What’s more, the struggles of Norwegian Air’s main legacy competitor, SAS, appear to be benefitting it. CEO Geir Karlsen said the airline was taking more corporate share in Scandinavia, with business revenues already above 2019 levels (admittedly off a low base). As good as the third quarter was, Norwegian Air still faces a cold winter ahead. Inflation and foreign exchange pressures are a concern even though the airline sees no slowdown in demand through at least December, Karlsen said. The airline has already cut capacity per plan by a quarter from its summer schedule, and more cuts could come in the first quarter if demand weakens. And Karlsen warned of “overcapacity” in Norwegian Air’s home market citing startup Flyr. Flyr has already slashed its schedule by more than half and involuntarily furloughed employees in order to survive the winter. For 2023, Norwegian Air plans to fly roughly 27 percent more capacity than it will this year.

Jay Shabat & Edward Russell

In Other News

  • Canada’s Competition Bureau last week threw cold water on WestJet‘s proposed purchase of leisure and holidays competitor Sunwing Airlines. The regulator found that the deal could “result in increased prices, less choice and decreases in service for Canadians,” and identified 31 routes where competition would decrease. WestJet, meanwhile, thanked the regulator and noted that the report was only “advisory and non-binding.” Canada’s Minister of Transport, Omar Alghabra, will issue a final decision on the deal.
  • Thai AirAsia flew 42 percent of its 2019 system capacity in the third quarter, the airline said last week. That represents a remarkable recovery for the discounter — the Thailand-based arm of Capital A’s AirAsia franchise — which flew less than 2 percent of its pre-pandemic capacity last year. Domestic, as with pretty much every airline around the world, was ahead of international at 62 percent of three years earlier compared to 43 percent, respectively. The airline has focused its international recovery efforts on Southeast Asia and South Asia, it said.
  • Australia’s Rex Airlines said its Boeing 737 passenger operations turned its first profit in September. The carrier, which launched in February after a series of Covid shutdowns, said revenues were up 137 percent in September compared to June. Rex maintains its forecast of a profitable 2023 fiscal year, which ends next June. The airline is also sourcing two additional 737-800s to complement the seven it flies. Rex’s 737 operations complement its turboprop regional business that spans much of Australia, and the new “fly-in-fly-out” charter business it acquired with National Jet Express at the end of September. 

Edward Russell

Edward Russell
October 31st, 2022 at 12:01 AM EDT

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