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Lufthansa analysis, Part 1 – Cutting capacity to boost profitability

When OneWorld members British Airways and Iberia together announced a 555 million Euro net profit under the umbrella of International Airlines Group (IAG), it provided almost a calming influence to the volatile European airline industry.

After financial failures of Hungarian carrier Malev and Spanish carrier Spanair, earlier this year, many in the global analyst community predicted further pain amongst Europe’s airlines. However, the EU’s largest carriers, IAG, Air France-KLM, and Lufthansa Group are not showing any signs of collapse. In fact, Lufthansa has been taking steps in the past four months or so, that will hopefully ensure their profitability for months to come.

Lufthansa is actually cutting capacity

One of the things that should have become abundantly clear after close to six months for me at Bangalore Aviation is that I’m a big believer in the power of capacity discipline and capacity cuts.

Europe’s airlines certainly need to show some capacity discipline in this time of crisis. While the US economy has finally shown signs of life over the past few months, and the economies of Asia, Latin America, Australia, and Africa have for the most part rip-roared back, Europe seems to be lurching from crisis to crisis.

A recent report from the European Central Bank (ECB) indicated that the consensus view of economists is that the Euro Zone will contract about 0.1% in 2012, with sluggish 1.1% growth resuming in 2013.

These economic conditions will naturally depress air travel, consistent growth in Asia and Latin America notwithstanding. Adding to these woes is the sky-rocketing price of fuel, which shows no sign of abating as tensions build, even fruther, around Iran, in the Middle East, as well as potential supply disruptions in Russia.

Lufthansa in particular is disproportionately affected by an increase in fuel prices because much of its long-range fleet consists of four-engined aircraft (Airbus A340, Boeing 747, and Airbus A380). So it was clear that Lufthansa would have to take action in order to shore up their profitability.

The speed of Lufthansa’s response to these factors was impressive to say the least. In the fall of 2011, Lufthansa first began to notice the warning signs that the European debt crisis was going to be a threat to the region’s economy, and their fortunes.

The first telltale move came in early November, when the carrier cancelled its five weekly Frankfurt-Calgary flights. This, was quickly followed by the cancellation of thrice weekly Frankfurt-Guangzhou services later in November, and the placement of Lufthansa’s thrice weekly Frankfurt-Kolkata into a permanent state of “bandh” (the Hindi term for a strike, which is so common in the city).

Lufthansa’s new ultra-slim ultra-light Recaro seats reduce weight and increase fleet capacity. Read story here.

New planned services from Munich to Mexico City and from Dusseldorf to Tokyo-Narita were shelved, along with service increases like Frankfurt to Nanjing, Newark, and Munich-Seoul-Busan.

The common thread for all of these changes, were that they were marginal routes; ones with very little Origin and Destination (O&D) traffic on the specific city pair.

Obviously, there is no specific formula for long haul success, but with one notable exception (Emirates/Qatar), the most successful long haul routes typically fall into one of two categories, more heavily the first of these two.

Long haul routes typically rely on a strong cadre of high-yielding origin and destination traffic, or on connecting unique traffic flows that have some sort of restriction on direct services ( i.e. distance for the Kangaroo route, or lack of capacity for Iraq).

It’s a little known fact, but the 10-15% of O&D passengers that ply a route can oftentimes represent up to 40% of revenues for that particular route. Similarly, even routes full of connecting traffic can be unprofitable for carriers like Lufthansa if the connecting traffic isn’t high yield enough or the O&D component is too small or too low-yield.

Each of the cancelled routes fits that mold. Kolkata is almost entirely low-yield connections through Frankfurt, as is Munich-Mexico City. All five routes lack significant O&D traffic, especially of the high yield type; though in the case of Dusseldorf-Narita, it likely had more to do with insufficient connectivity.

Either way, Mexico City is probably better served by flowing traffic through Frankfurt, and ditto for Narita via Munich and Frankfurt. Guangzhou and Nanjing are both secondary Chinese cities (from an international travel perspective), and Munich-Seoul does not have a ton of O&D traffic. All in all, these are marginal routes where there is little necessity for new service, continued, service, or added frequency.

Ultimately, these kinds of moves will likely boost Lufthansa’s profitability ahead and above that of its two main continental competitors, IAG and Air France-KLM. Air France-KLM has taken the opposite tack, and they’re liable to feel pain for it in the near future. Sure they’re dropping a few marginal destinations like Orlando, but at the same time, they’ve been adding capacity to the Far East at an alarming rate.

While the Far East is certainly a growing market to and from Europe, the sudden up-tick in capacity and fuel prices mean that many of these routes will be unprofitable at the start (potentially ramping up to profitability down the line).

Lufthansa, in contrast, has been far more active in cutting such services, and that will pay its own dividends. The airline industry is unique in that investors and managers alike sometimes have a tendency to think too much of expansion, and not enough of profitability. Lufthansa’s actions are designed to boost profits, as capacity cuts are wont to; and that makes Lufthansa a brilliant player relative to many of its peers. As the Euro zone (figuratively) burns, they are taking the right steps to ensure that they are not left fiddling.

This is just Part 1 of Bangalore Aviation’s analysis of Lufthansa. Part 2 will cover the carrier’s India strategy and further installments will come out leading up to the carrier’s financial results on March 15th, which will be analyzed as well.

Stay tuned. In the mean time, as usual, comments are solicited and welcomed.

About Vinay Bhaskara

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