Is Consolidation the Answer to Lufthansa’s Paltry Profits?
Pushing Back: Inside the Issue
The second quarter earnings results keep rolling in, depicting an airline industry enjoying a resurgence in demand, but also a shortage of supply, especially of people and planes.
Korean Air stole the show with a thundering 22 percent operating margin for the quarter, taking advantage of Seoul’s status as a leading global cargo hub. Perhaps it’d be best off abandoning the passenger business altogether. Passenger and cargo strength alike helped Turkish Airlines deliver strong June quarter profits. The Middle Eastern LCCs Air Arabia and Jazeera Airways posted solid profits as well. Things were much tougher, on the other hand, for Cathay Pacific in Hong Kong, where air traffic volumes remain a fraction of what they once were. On the other side of the earth, Latam posted another operating loss as it nears an exit from bankruptcy court in the U.S. But Azul was again profitable, in what is an off-peak period for Brazil.
Finally, Boeing is delivering 787s again. Airlines continue to cut flights to ensure smoother operations. And for some in the U.S., the peak summer season is now already largely finished, with schools back in session throughout much of the country.
Airline Weekly Lounge Podcast
Meet Steve Sisneros, the airport czar at Southwest. As vice president of airport affairs, he oversees current and future real estate at the airline’s 121 airports. Edward Russell and Sisneros chat about Southwest’s new facilities in Denver and Phoenix, and the status of Terminal 0 plans in Los Angeles. Listen to this week’s episode to find out. A full archive of the ‘Lounge is here.
Weekly Skies
Round of applause for Korea’s largest airline. Thanks to one of the industry’s largest air cargo operations, Korean Air sailed through the pandemic with consistent operating profits. Last quarter, with cargo still booming amid bottlenecked global supply chains, the airline delivered grand slam earnings once again, with an operating margin reaching a stratospheric 22 percent. That displaces Southwest Airlines’ 17 percent as the highest margin of any passenger airline reporting so far. It’s also a level that Korean Air could barely dream of before the pandemic, when it was at best a modestly profitable airline. In 2019, it managed just a 2 percent operating margin, alongside a steep net loss. Let’s be clear: Korean Air has basically been just a cargo airline these past two-plus years. A full 77 percent of its revenues came from cargo, with passengers contributing just 11 percent. In 2019, cargo was 24 percent of revenues. Note that the company has an aerospace manufacturing business and other subsidiaries as well. Looking ahead, Korean Air expects passenger traffic to recover more slowly than originally forecast for the second half of 2022, owing to lingering travel restrictions in Asia, as well as high oil prices and its impact on economic growth. For now, more than half of its passenger revenues are coming from routes to and from the Americas, with the key Chinese and Japanese markets still largely dormant. One notable strength currently — as Japan’s ANA and JAL recently noted — is with people connecting between North America and Southeast Asia via Seoul Incheon. Japan is now slowly opening up and China is relaxing quarantines. Korean Air still seeks to merge with rival Asiana, which ran out of money early on in the pandemic.
Turkish Airlines is also a pandemic success story. While nowhere near Korean Air or Southwest’s operating margins, its own 12 percent number in the second quarter is respectable. That is especially true considering that it did it on the back of the return of long-haul connecting passengers — a segment that is still in the early stages of recovery for Korean Air. Turkish Chief Financial Officer Murat Şeker attributed its results to the early restoration of its long-haul network that gave it a “first mover advantage” over its European competitors, as well as a strong local market. Being one of the few international airlines still serving Russia was also a benefit for Turkish financially, thought Şeker said the yield gains were partially negated by the loss of traffic to both Russia and Ukraine. No matter the reason, Turkish’s results were impressive: total revenues increased nearly 43 percent year-over-three-years to $4.5 billion on 12.3 percent more passenger capacity. Cargo revenues alone soared 171 percent to $1.1 billion. Turkish turned an operating profit of $520 million, and a net profit of $576 million. The airline anticipates further capacity growth compared to 2019 in the second half — 10-20 percent in the September quarter, and 5-15 percent in the fourth quarter — and profits for the full year.
Several months before anyone ever heard of Covid-19, civil unrest caused Hong Kong’s air traffic to plummet. Now, several months after international air travel has begun rebounding from Covid elsewhere the world, Hong Kong’s air traffic remains severely depressed. For Cathay Pacific, Hong Kong’s top airline, it’s been three full years and counting of downright misery. Thank goodness for cargo, which prevented an even nastier financial massacre. But cargo too, was impacted by strict quarantine rules for air crews, which prevented Cathay from flying a full schedule of freighters. Last week, Cathay unveiled a $641 million net loss for the first six months of 2022, with a chunk of that attributable to its 18 percent stake in money-losing Air China. HK Express, Cathay’s low-cost unit, itself posted a $106 million net loss for the half-year. The core flying operations of Cathay suffered a negative 4 percent operating margin, which again would have been worse if not for strong cargo demand. In addition, Cathay enjoyed a $255 million fuel hedge gain, though that still doesn’t erase bad memories of massive hedge losses in years past. There’s at least some brightness on the horizon. Quarantines have been steadily relaxed, and Cathay foresees about a quarter of its pre-pandemic passenger capacity returning by the end of the year. To prepare, it plans to hire more than 4,000 front-line workers. Uncertainty, however, still looms large. Hong Kong’s status as a global hub is in doubt following major changes in its relationship with mainland China. In a case of terrible timing, the changes came just as Hong Kong’s airport opened what was once a badly needed third runway.
A few other brief earnings updates from around East Asia: Taiwan’s China Airlines, despite heavy cargo exposure, only managed a 3 percent operating margin for the April-to-June quarter. Its similarly-sized rival Eva Air, also a major cargo player, did better at 7 percent. Besting both was Philippine Airlines, a longtime financial basket case that got a burst of life from its controlling family — a burst in the form of a half-billion dollars in new capital — and a U.S. Chapter 11 bankruptcy restructuring that wrapped at the beginning of the year. With the help of cargo, plus a large diaspora of overseas Filipino workers that still needed to get places during the pandemic, PAL had an excellent first half of 2022, highlighted by an 11 percent operating margin. This was its first money-making first half since 2016.
Much ink has been spilled about the future of Spirit Airlines. Its planned merger with Frontier Airlines is off and a deal with JetBlue Airways is on after the latter won a bidding war for the Florida-based discounter. But, as CEO Ted Christie said last week, it’s “business as usual” at the airline for the time being. And that means recovering from the pandemic that, due primarily to what executives called U.S. aviation infrastructure issues — including but not limited to air traffic control staffing issues at the FAA’s Jacksonville center — will not occur until next year. Spirit underutilized its staff and aircraft by roughly 15 percent in the second quarter; or, put another way, its planes flew about 2 hours less per day than they did in 2019. That, coupled with high fuel prices, pushed perennially profitable Spirit to a $45 million operating loss and a negative 1.2 percent operating margin in the second quarter. But once the airline trains all its new staff, and the infrastructure issues ease, the demand is there to support a successful Spirit. Revenues jumped 35 percent year-over-three-years and unit revenues 23 percent. Capacity was up nearly 10 percent compared to 2019.
Sun Country Airlines faced challenges achieving a full pandemic recovery in an area that has become all too common among U.S. airlines: staffing. The Minneapolis-based carrier has all the pilots and crews it needs, but it faces a training backlog that is not expected to ease until at least the end of the year. Sun Country, which operates a resilient business model that includes scheduled passenger, charter, and cargo flights, was forced to dedicate the pilots it had to the latter two categories to meet its contractual obligations; that forced it to fly less higher-yielding passenger capacity than it wanted in the second quarter. “We weren’t able to add … flying due to crew constraints,” CEO Jude Bricker said last week. The good news for Sun Country is the June quarter is historically one of the weakest on its calendar, and the year-end target to get all of its crews through training sets it up well for its busiest period next year, the January-March quarter. In the meantime, Sun Country posted a $3.4 million operating profit and $3.9 million net loss in the second quarter. Revenues and passenger unit revenues — not including its charter and cargo businesses — both jumped 29 percent compared to 2019.
The last thing anyone expected of Latam Airlines Group pre-pandemic was a U.S. bankruptcy filing. But with limited government support to cushion the epic demand shock, South America’s largest airline had little choice but to seek protection from its creditors two years ago. Now, as demand starts to normalize, Latam still faces challenges, including more cost-competitive rivals, several of whom underwent their own bankruptcy restructurings. Latam itself hopes to exit bankruptcy in the fourth quarter, with help from financial backers Delta Air Lines and Qatar Airways, after a judge approved its restructuring plan in June. Delta is particularly important strategically, teaming with Latam to form a “TransAmerican” joint venture that the U.S. DOT tentatively approved last month. Latam is separately expanding its dedicated freighter fleet and building on early post-pandemic passenger strength in its major domestic markets (i.e., Brazil, Chile, and Colombia). The airline’s domestic capacity, in fact, has already surpassed 2019 levels. Latam did lose money in the second quarter, however, posting a negative 8 percent operating margin.
Brazil’s Azul, which attempted a hostile takeover of Latam during the larger rival’s bankruptcy, has performed strongly of late. Like Gol, it did post a large official net loss last quarter, tied to the accounting treatment of foreign exchange movements. Unlike Gol, however, which posted a negative 6 percent operating margin, Azul turned in a 3.5 percent operating profit margin. Azul was 36 percent larger in the second quarter than it was in 2019, measured in available seat kilometers. Before the pandemic, Azul was already taking advantage of Avianca Brasil‘s collapse and, after the crisis began, of Latam‘s capacity cuts in bankruptcy. A number of other factors also explain Azul’s success. One is a collection of high-margin auxiliary businesses, including cargo, loyalty, and vacation packages. Many of its routes face no direct competition. New Airbus A320neos and Embraer E-Jet-E2s are serving it well. Azul is now poised to roughly double its presence at São Paulo’s high-yield, corporate-heavy downtown Congonhas airport thanks to government slot reallocations.
The demand recovery was no less palpable in the Gulf region of the Middle East, where two low-cost carriers reported solid second quarter results. Air Arabia‘s operating margin was 14 percent, while the figure for Kuwait’s Jazeera Airways was 11 percent. Air Arabia, based close to Dubai in neighboring Sharjah, added 16 new routes in the first half of 2022, not just from its home base but also from Morocco, and Egypt — it operates joint-venture airlines in both places. It’s now backing new airline ventures in Pakistan and Armenia. Jazeera is adding routes too, with Qauassim coming online later in August following the additions of Prague, Vienna, and some additional destinations in Saudi Arabia in June and July. LCCs are watching as the Saudi government looks to develop more tourism. There’s new competition, however, from startups like Wizz Air‘s new Abu Dhabi venture, and possible Saudi venture. Air Arabia has a two-year old Abu Dhbai-based joint venture in partnership with Etihad Airways as well. For Jazeera, by the way, a quarter of its demand comes on routes to India, with Egypt accounting for another 18 percent.
U.S. regional Mesa Air Group said traffic in the second quarter remained strong, “and our partners continue to request more hours,” i.e., flying assignments, but that “the industry-wide pilot shortage impeded our ability to meet that demand.” CEO Jonathan Ornstein last week described the U.S. regional sector as “caught in an unprecedented squeeze,” characterized by the “highest levels of pilot attrition in history and a shrinking pool of qualified commercial pilots without the necessary amount of hours.” Mesa’s problem is in one sense the same problem faced by its partner airlines: under-utilization of planes and other assets. “You’ve got these high-cost fixed assets that you just have to fly.” Ornstein added: “when you think about it, who would have ever thought that it’s easier to go into Covid than it was to go out of Covid.” Mesa, by the way, reported a roughly breakeven second quarter operating margin.
— Edward Russell and Jay Shabat
In Other News
- Allegiant Air priced $550 million in senior secured notes due in 2027 at a coupon of 7.25 percent last week. Proceeds from the issue will be used to refinance the $533 million outstanding under the Las Vegas-based carrier’s variable-rate Term Loan B due in 2024. The notes are secured by Allegiant’s non-aircraft assets, including its loyalty program and intellectual property; Allegiant’s Sunseeker Resort is excluded from the collateral pool. Fitch Ratings, which rated the debt a speculative BB+, noted that the transaction smooths out Allegiant’s debt maturity profile that previously peaked in 2024, and gives the airline financing flexibility for its new Boeing 737 Maxes that begin arriving next year. The transaction also involves a new $100 million revolving credit facility due in 2024, per Fitch.
- The U.S. is considering creating airline seat size standards for the first time in history. Earlier in August, the Federal Aviation Administration solicited comments on “minimum seat dimensions necessary for safety of air passengers.” It will accept responses for 90 days, or until November 1. The move comes amid increasing pressure to rectify what passenger advocates say is a health and comfort problem: ever-shrinking airplane seats even as Americans have gotten larger. The FAA was first mandated to do something about seat size in its last funding reauthorization bill in 2018. “The FAA has been slow rolling this thing for going on four years,” FlyersRights President Paul Hudson said.
- Frontier and Denver International Airport broke ground last week on a $183 million expansion of the ground-level boarding gates on the airport’s Concourse A. The budget airline will move to what will be a 14-gate facility after construction wraps in 2024. “The use of ground boarding will cut boarding and deplaning times in half by allowing customers access to aircraft from the front and rear and will help support our expansion” in Denver, Frontier CEO Barry Biffle said.
— Edward Russell & Ted Reed
Fleet
- Boeing resumed deliveries of its flagship widebody, the 787, on August 10. American Airlines took the first delivery in more than a year, a 787-8 with registration N880BJ. The American aircraft was one of 11 787s that were originally due last year but delayed due to Boeing’s production quality issues. The Fort Worth, Texas-based carrier expects seven more aircraft this year, and a further four in 2023 after rejigging its 787 delivery schedule in February. Hawaiian Airlines, Lufthansa, and United Airlines, among others, also expect delayed 787s from Boeing in the coming months.
Boeing suspended deliveries in May 2021 due to quality issues found in aircraft coming out of its North Charleston, S.C., factory. Those prompted a Federal Aviation Administration review, and sign off of the planemaker’s proposed fixes that was not completed until earlier in August. “Boeing has made the necessary changes to ensure that the 787 Dreamliner meets all certification standards,” a FAA spokesperson said. However, they added that the regulator will inspect and sign off on every aircraft before it is handed over to an airline. - AerCap, the world’s largest aircraft leasing company, joined other lessors this earnings season in highlighting some key trends in the aircraft market. One is that supplies are limited with Airbus and especially Boeing hobbled by production and regulatory challenges. The resumption of 787 deliveries (see above) comes as widebody demand is starting to rekindle, with AerCap noting an uptick in inquiries about availability. Narrowbody demand, meanwhile, has remained rather robust throughout much of the Covid crisis. Air Lease Corp., in its June quarter earnings call, highlighted the popularity of the A321neo, including the LR and XLR versions, which “now have forward placements out 5 years through 2027, farther out than we had pre-Covid.” One great question for the aircraft market is whether China will once again be a major player, which most lessors expect it to be. As AerCap pointed out, the country buys perhaps a quarter of all the planes Boeing and Airbus produce. The comments come a month after China’s big three ordered nearly 300 new Airbus narrowbodies. Events in Russia caused some lessors to lose access to planes, but the market was never really that large. AerCap CEO Aengus Kelly said: “There is no question that leasing is growing much faster than I had expected before the pandemic … we’re probably looking at 65 percent of all deliveries will end up in the leasing channels.”
- United has made its first downpayment on what could amount to as many as 200 Maker electric vertical takeoff and landing, or eVTOL, aircraft from Archer Aviation. The carrier made a $10 million pre-delivery payment to Archer last week for the aircraft, which remain in development — and a long way from certification — despite assurances from Archer that it will begin deliveries in 2025. United appears the first to make an actual payment for eVTOLs; most other deals are just tentative with American the furthest along having given Vertical Aerospace a “pre-delivery payment commitment” in July. Separately, Archer posted a nearly $72 million net loss in the second quarter but had nearly $655 million in capital as it continues work on the Maker eVTOL.
Routes and Networks
- Avianca plans to add six new routes as it continues to expand point-to-point flights across its map. The Star Alliance airline is seeking approval from Colombia’s civil aviation regulator to add daily flights between: Cartagena and Santiago, Chile, and São Paulo Guarulhos; Medellin and Armenia and Pereira, Colombia, as well as Aruba; and Pereira and New York JFK. All of the routes would be flown with Airbus A320 family aircraft. Avianca would compete with EasyFly and pending merger partner Viva Air on the two domestic routes from Medellin, per Diio by Cirium.
- And speaking of Colombia, Latam Airlines Group wants to begin what would be the only nonstop between Bogotá and Caracas since 2021. The carrier has sought authority from Colombia’s civil aviation regulator to offer daily flights on the route with A320-family aircraft. Copa Airlines‘ budget arm Wingo was the last to fly the route in 2021, with Venezuelan airlines Avior and Laser having suspended service in 2020, per Diio by Cirium.
- Delta Air Lines continues to make cuts at its Detroit and Minneapolis-St. Paul hubs. The former loses nonstops to Allentown, Pa., on September 10, and Cedar Rapids, Dayton, and Fort Wayne on October 5, per Diio by Cirium. Flights between Minneapolis and Moline, Ill., also end October 5. The reductions come as Delta adds a new route from its Boston hub: thrice-daily service to White Plains, N.Y., from October 6. Airline Weekly understands that, broadly, Delta is focused on recovering capacity at its coastal hubs, where it made the deepest cuts during the pandemic, due to various contractual and regulatory reasons; for example the return of slot use it, or lose it rules in New York earlier this year. Given limited resources, particularly staffing at its regional affiliates, the airline has used cuts in Detroit and Minneapolis to free resources for its recovery on the coasts.
- David Neeleman’s startup Breeze Airways is adding a new base in Providence, and a new dot on its map, Phoenix. The Rhode Island capital base will open next year and support up to eight aircraft within four years, or by 2027. Breeze plans to expand its Providence network from five routes to as many as 20 over that same period. Nearer term, Breeze will begin service to Phoenix from Charleston, S.C., and Provo, Utah, on November 2. The additions are part of a six route expansion that also includes: Charleston to Los Angeles from November 4; Tampa to Syracuse from November 19; and White Plains, N.Y., to Nashville and Sarasota/Bradenton from November. But it’s not all additions at Breeze, the airline will also drop planned or short-lived flights between White Plains and both Las Vegas and San Francisco.
- WestJet continues to tweak its map as it slowly shifts capacity to its western Canada roots. The airline has dropped plans for seasonal flights between Phoenix and Toronto this winter, and added new seasonal service between the Arizona capital and Winnipeg thrice weekly from October, and Kelowna weekly from November, per Diio by Cirium. Both new routes will operate through April. In addition, WestJet will launch new six-times weekly flights between Vancouver and Penticton, British Columbia, with 30-seat Saab 340 aircraft from February 17.
State of the Unions
They say imitation is the greatest form of flattery. That maxim is proving true in the U.S. regional airline sector as it looks to combat a pilot shortage that threatens air service to small communities across the country.
SkyWest Airlines’ proposal for a new operating subsidiary, SkyWest Charter, would imitate a model that has proven successful for many others. It hopes the move, which would complement its core business flying planes under contract for major carriers, would expand its supply of pilots — particularly captains — and allow it to continue flying to at least 20 smaller cities across the U.S. that it has proposed dropping.
“It’s SkyWest mimicking our operating structure exactly,” Contour Airlines CEO Matt Chaifetz said. “The world’s largest regional airline sees merit in what we’re doing, I welcome the competition and will also take the moment to relish that we have been doing something right.”
What Contour does is fly under what the U.S. Federal Aviation Administration defines as “Part 135” public air charter airline, rather than “Part 121” regularly scheduled air carrier that includes everyone from SkyWest currently to American Airlines. While the difference between the two is largely indiscernible for passengers, the rules around pilots differ in several key ways: one, first officers at 135 airlines only need at least 250 hours of training as opposed to 1,500 hours at 121 carriers, and there is no mandatory retirement age. A downside is that the former can only fly planes with up to 30 seats, and it cannot operate as an “express” airline under a contract with, for example, Delta Air Lines.
Changing the operating model is not the only answer to the pilot shortage. One method, taken by Alaska Airlines and United Airlines, is to start a flight school and provide financial aid to attract more people to the profession. That approach, however, takes years to produce new, certified cockpit crew members. Another is to raise entry-level pilot pay to attract crews; American has taken this path with its affiliates. Some argue that this approach effectively robs Peter to pay Paul because the overall supply does not change. And a third, as proposed by Senator Lindsay Graham (R-S.C.) in July and first reported by Airline Weekly in May, would be to raise the mandatory retirement age by two years to 67.
U.S. airlines are likely to hire around 12,000 new pilots this year, and another roughly 8,000 in 2023, according to a recent report by Raymond James analyst Savanthi Syth. She estimated that there are enough overall pilots to meet this demand but that captains, which require more hours — regardless of a 135 or 121 certification — than entry-level crew members, were a constraint for regional airlines.
The ranks of 135-certified airlines include Cape Air, private-like JSX, and Southern Airways Express. Many have not faced the same issues hiring and retaining pilots as their 121 competitors.
“The [pilot] issue is not easier,” Chaifetz said when asked about pilot staffing as a 135 operator. In his view, attracting and retaining pilots is a combination of offering competitive pay on aircraft crews who want to fly with flexible work-life balance. Contour, he said, starts captains at a competitive $118,000 a year, flies Embraer ERJ regional jets rather than single-engine propeller planes, and offers paid commutes from a pilot’s home to work.
Higher pay and free commutes from home come at a cost though. The point-to-point flying that Contour did before the pandemic — for example, between Santa Barbara and Sacramento in California — is gone now due to poor economics in favor of routes that benefit from the Department of Transportation’s Essential Air Service subsidy program. Chaifetz said communities outside of the program may need to create their own permanent incentive programs to maintain commercial air service.
“With labor rates, and fuel where it is, a lot of these markets are going to need continuous subsidy if they want to retain service,” he said.
As Chaifetz said, simply being a 135 airline does not guarantee a supply of pilots. Cape Air, for one, has struggled with cockpit crew staffing. However, most pilots at the Massachusetts-based airline need to have at least 1,200 hours — the requirement for captains at public charter carriers — as opposed to 250 hours for first officers because most of Cape Air’s flights operate with a single crew member.
“What makes Contour different is we have the right aircraft, the right gauge,” Chaifetz said of attracting pilots, and particularly captains.
Captains appear to be the challenge at SkyWest as well. During the Utah-based airline’s second-quarter results call on July 28, CEO Chip Childs said they were its “largest constraint” to flying more owing to the fact that, in his words, “SkyWest pilots being the most sought after in the industry.” The carrier is working to add new incentives to retain pilots and captains and to reduce attrition. But even with these moves, Childs said pilot staffing will likely constrain capacity until the end of 2023 or early 2024.
“The captain supply is what becomes most intriguing to us because of the [level of] … interest that we’ve seen from existing experienced captains in the industry that want to participate in this operation,” Childs said in response to questions on how SkyWest Charter addresses the pilot situation. “To the extent that the pilot supply thing works with this, I think it does help out on the captain side because you need captains to create captains.”
Entry-level pilots, or first officers, must fly with a captain until they upgrade to what is called the “left seat;” a reference to the captain’s chair in the cockpit.
For now SkyWest must wait for the DOT to sign off on its SkyWest Charter plan. Childs expects flights to begin in the fourth quarter or, at the latest, early in 2023.
Labor Briefs
- Customer service agents, stores and cargo staff, and ground service and reservations agents at Alaska Airlines have ratified a new contract. The roughly 5,300 employees represented by the International Association of Machinists and Aerospace Workers will receive an immediate 8.9-17.4 percent raise, and another 2.5 percent pay increase in August 2023 under the accord. The contract, which becomes amendable in September 2026, includes additional industry pay reviews in 2024 and 2025, as well as job protections through 2028.
- Pilots at David Neeleman’s latest startup Breeze Airways have voted to unionize, according to the Air Line Pilots Association. The airline plans to challenge the election because it was limited to just active Breeze pilots on March 31, which was a smaller pool and before it began Airbus A220 operations. ALPA, for its part, expects the U.S. National Mediation Board to certify the election in the coming days.
Feature Story
Who remembers this? In 2007, just before the global financial crisis, the Lufthansa Group purchased a 16 percent ownership stake in JetBlue Airways. The idea: To establish greater influence in New York, America’s largest airline market. Ultimately, the move proved much ado about nothing. Lufthansa’s close partner United Airlines would merge with Newark powerhouse Continental Airlines in 2010, giving the German giant all the Big Apple bulk it needed. In 2015, it quietly sold its JetBlue shares, consigning the investment to a forgettable footnote of airline history.
Fast forward to 2022, and Lufthansa is again contemplating an investment in a foreign airline. This time it’s Italy’s ITA Airways, the successor of longtime laughingstock Alitalia. Lufthansa has teamed with the shipping giant MSC to buy 80 percent of ITA, thus providing more clout in the large Italian market — Western Europe’s third largest. During Lufthansa’s second quarter earnings call, CEO Carsten Spohr called Italy the group’s “most important market beyond our home markets.” He’s alluding to the rich vein of corporate traffic sourced from Italy’s wealthy northern regions, funneled through the airline’s primary hubs in Frankfurt, Vienna, Zurich, and especially Munich. “We need a stronger position in Italy, one way or another,” he said, “hopefully together with ITA.” If an ITA deal doesn’t happen? Lufthansa will grow its own Italian airline, Verona-based Air Dolomiti, of which it holds 100 percent control.
Make no mistake. Lufthansa looks west with envy, mindful of how major mergers have introduced financial stability and strength to the once-chronically-ill U.S. airline industry. Europe, by contrast, remains highly fragmented, not just within the continent but also on intercontinental routes. Lufthansa has certainly done its part to help address the problem. Since 2005, it’s built itself an empire of airlines. One has been a diamond — its takeover of Swiss, most importantly, was one of the greatest airline acquisitions of all time, yielding profit margins consistently higher than the Lufthansa-branded airline itself. Some, on the other hand, have been duds, including Austrian, Brussels, and Eurowings, all with loss-making histories.
On balance, this consolidation hasn’t created a platform for strong groupwide profitability. From 2015 to 2019, a half-decade with rather lowish average fuel prices, the group earned just a 6 percent operating margin on roughly $200 billion in revenues. Its partner United, during that same period, did twice as well: A 12 percent operating margin on essentially the same amount of revenues.
Maybe ITA and a stronger Italian franchise might get Lufthansa closer to U.S.-like profit margins. It’s surely keeping at least one eye on events in Scandinavia, where the bankruptcy and labor woes of SAS create more leverage to potentially strike (pun intended) an advantageous takeover deal. Markets like Denmark, Norway, and Sweden are somewhat less well positioned than Italy for feeding traffic into Lufthansa’s main hubs. Also, unlike Italy, long a SkyTeam-dominated market, Scandinavia is already Star-affiliated, limiting the upside of a SAS takeover. In addition, SAS doesn’t have any unique geographic niches, like Brussels does in Africa or Austrian does in eastern Europe and the former Soviet Union. SAS doesn’t even dominate its home hubs, with Copenhagen, Oslo, and Stockholm infested with low-cost competition. Still, there’s gold in them hills — Scandinavia is a wealthy market with an abundance of globetrotting corporate traffic. Might wealthy Scandinavian travelers do for Lufthansa, what Switzerland’s wealthy travelers did for it? On the other hand, might SAS be merely another headache for Lufthansa, like Austrian and Brussels have been?
Lufthansa now talks about a new post-pandemic normal for the industry, which it foresees featuring a “higher level of consolidation.” That presumably includes consolidation undertaken by others. It likely means overseas joint ventures as well, like Lufthansa has with United and Air Canada across the Atlantic, and with Air China, All Nippon Airways, and Singapore Airlines to East Asia.
Lufthansa, to be sure, is taking other steps to achieve more robust profit margins — its goal, by the way, is an operating margin of at least 8 percent by 2024. One critical piece of reform involves its fleet. Lufthansa gets no prizes for aircraft strategy. In decades past, it bet wrongly on four-engine passenger jets like the Airbus A340 and A380, and the Boeing 747-8. It watched with envy as Air France wisely made the Boeing 777-300ER the centerpiece of its longhaul fleet — only very late did Swiss add a handful of -300ERs, which by all accounts have served it extremely well. Having learned its lesson on twin-engine widebodies, Lufthansa was an early buyer of Boeing’s 777-9. Alas, that’s a plane few others seem to want, arguably destined to become another A380; i.e., a plane with too much capacity, too much complexity, not enough new technology, and overlapping in capabilities with some of Boeing’s own 787, including the extended range 787-10 that it plans to build.
Dreamliners, to be sure, are part of Lufthansa’s long-term fleet plan as well — it ordered them later than most, but better late than never. It’s also betting on Airbus A350-900s. And with respect to narrowbodies, Airbus A320 family and A220 aircraft dominate. That’s a path toward helpful fleet simplification. And besides, even those 777-9s will in fairness be more useful to Lufthansa than others given the jet’s promising cargo capabilities.
Cargo is hardly an afterthought. It’s what saved Lufthansa from a much grizzlier fate throughout the pandemic. It’s also a business that produced a spectacular 38 percent operating margin last quarter, contributing about 15 percent of the group’s total revenues and $600 million in operating profits. Without that contribution, the group would have lost money in the second quarter.
Indeed, total operating profit for the quarter was just $491 million, good for a mediocre 5 percent margin. The robust demand recovery notwithstanding, the Lufthansa-branded passenger operation suffered a negative 2 percent margin. Eurowings, still not healthy after countless restructurings, delivered a negative 14 percent margin. The similarly troubled Brussels came in at negative 9 percent. Austrian managed to rise just above breakeven. Conversely, Swiss again was a success, matching KLM for best airline operating margin in Western Europe last quarter: 9 percent. The group’s giant aircraft maintenance division — with more revenues than either cargo or Swiss last quarter — did well too with a 7 percent margin.
Enacting structural changes across such a multivariate empire isn’t easy. But Lufthansa hopes to use complexity to its advantage in at least one respect. Having so many different airlines is a tool it can use to arbitrage labor costs. During its second quarter earnings call, management made it perfectly clear it would never move to uniform pilot pay across the group, even within Germany. “To come to one overall pay scale system for all the airlines in Germany is, for us, a strategic no-go,” Chief Financial Officer Remco Steenbergen said. “We cannot do that because that will really put our company at such a strategic disadvantaged position against the other airlines.” Having different pay scales under one corporate roof is not something practically possible in the U.S. given labor-management circumstances there. Of course, this labor arbitrage game is one Lufthansa has been playing for years, most notably in its development of Eurowings.
Even so, Eurowings has repeatedly lost money, despite its lower labor costs, and some favorable pre-pandemic competitive developments, like the collapse of rivals Air Berlin and Thomas Cook. The ineffectiveness of Eurowings stems from multiple shortcomings, including its operational complexity. The LCC began life as Germanwings, established to handle point-to-point shorthaul traffic that didn’t touch the group’s Frankfurt or Munich hubs. Over time, it morphed into a new platform called Eurowings, added longhaul flying, took responsibility of Brussels and Sun Express Germany, inherited the assets Lufthansa purchased from Air Berlin, refocused on hub flying, and so on. Most recently (July 2021), the group launched yet another iteration of Eurowings, this time called Eurowings Discover, modeled on Swiss’s successful leisure subsidiary Edelweiss and focused on longhaul and shorthaul leisure flying from Frankfurt and Munich. The core Eurowings (now simplified with fewer operating certificates) remains focused on serving passengers based in non-hub cities, most importantly Dusseldorf. Keep in mind that Germany has a much more decentralized economy and population than either Paris-centric France or the London-centric UK.
This decentralization helps explain why roughly 70 percent of Frankfurt’s airport traffic is connecting, compared to just 50 percent for Paris Charles de Gaulle and 30 percent for London Heathrow. This dependence on transfer traffic requires lots of shorthaul flying to support longhaul flying. The problem is, shorthaul flying is a bloodbath for European airlines not named Ryanair, EasyJet, Wizz Air, or, for that matter, the successful low-cow cost platforms developed by International Airlines Group (Vueling and Iberia Express) and Air France-KLM (Transavia). Eurowings ears many scars from assaults by LCCs like EasyJet.
As Spohr pointed out in the group’s second quarter earnings call, Germany now accounts for just 30 percent of total ticket sales. The majority of its 11 airline operating certificates, furthermore, are based outside of Germany. That’s somewhat comforting as Germany faces a difficult time economically, challenged by unsettling exposure to Russian energy and overseas exports (of autos especially, many sold in China). But selling outside of your home market is always more challenging than selling from within. That’s why sales help through international joint ventures — as well as control of markets like Austria, Switzerland, and perhaps Italy via acquisition — is so appealing. European loyalty plans, remember, simply don’t have the influence and reach they do in the U.S. Lufthansa’s Miles & More program has a mere 35 million members compared to United MileagePlus’ 100 million.
As it surveys the new realities of post-pandemic travel, Lufthansa is pleased to see premium demand perform well. It often claims to have more premium seats flying than any other airline, including premium economy seats which are performing extremely well this summer. On the other hand, it’s less exposed to leisure traffic than most global carriers, with Germany, Switzerland, and Austria attracting many fewer tourists than countries like France, Spain, the UK, and Italy. Lufthansa has historically had more Russia exposure than either Air France-KLM or IAG. It has more Asia exposure as well, currently a liability. China, in particular, is a market where Lufthansa invested heavily under its Air China joint venture. Just prior to the Covid shock, according to Cirium schedules, the Lufthansa Group served five cities in mainland China from Frankfurt, as well as Beijing and Shanghai from Munich, Vienna, and Zurich. Will demand to support those routes ever come back?
What should come back, if not entirely, is Lufthansa’s lucrative international corporate traffic. During the first quarter of this year, it flew just a fifth or so of its normal level of corporate travelers. That doubled to around 40 percent by June. Based on bookings, that’s moving to more like 50-60 percent of pre-crisis levels in the third quarter. Management targets a 60-70% recovery by year-end, and a new normal of about 80 percent, factoring in expectations that some corporate demand will be permanently lost to video conferencing and other new work practices.
This summer, the more immediate issue is stabilizing operations after a tumultuous spring. “For the complex air traffic system,” said Spohr, “the ramp-up curve from just 20 percent to 80 percent in just a few weeks, to be honest, was just too steep.” He added: “The overload of the system was caused by industry-wide staff shortages and on top, partly caused by … high sickness rates.” The Russian airspace closure added further complications, as did a shortage of aircraft and spare parts. Lufthansa has faced labor unrest too, leading to new contracts for ground workers. And, like most airlines, the group faces the problem of asset-underutilization in advance of having all its pre-crisis capacity restored.
On a more encouraging note, Lufthansa is well-hedged on fuel. An exodus of senior pilots and other workers heralds downward momentum in labor costs through juniority (long-tenured airline staff earn much more than newcomers). The many airlines in the group enable management to play a game of carrot and stick, delivering capital and capacity growth to successful subsidiaries, and the opposite to those that lose money. Sure enough, Cirium seat capacity figures show Swiss grew 19 percent from 2005 to 2019, while Lufthansa mainline grew just 9 percent. Interestingly, Austrian, Brussels, and Eurowings grew even faster as executives sought to push more production to the lowest-cost platforms. But as financial results show, this hasn’t been a recipe for higher margins.
To achieve that, Lufthansa will next turn to a revamp of its inflight premium products — stay tuned for announcements this fall. In the meantime, strength in the critical transatlantic market this summer should help keep cash flowing in, enabling the repayment of state aid provided early in the crisis. Lufthansa plans to divest a stake in its maintenance unit, while selling off its travel payments and catering businesses. The carrier’s first 787 should arrive soon now that deliveries have resumed (see Fleet). Importantly, emergency cost cutting during the pandemic lowered the company’s fixed cost base by more than $3.5 billion. Close cooperation with Germany’s passenger rail operator Deutsche Bahn should provide more connecting traffic while advancing environmental goals. Digitalization, personalization, direct distribution, reduced complexity, corporate simplification, and sustainability are all priorities.
The most important factor shaping the future of Lufthansa’s profitability, however, might very well be the consolidation it so craves. As its latest annual report states: “Although the pace of consolidation in the airline industry has slowed temporarily but significantly as a result of the coronavirus crisis, the Lufthansa Group still aims to drive the consolidation of the airline sector.” Let’s see what happens in Italy.
By the Numbers
