Wednesday, January 25, 2017

Published article on the alleged Lufthansa Etihad merger

The news hit me hard: an Italian newspaper reported that Etihad Airways has offered to buy 40% of Lufthansa’s shares with the intention to eventually merge the two carriers altogether. Or, as an industry colleague of mine put it: HOLY COW!

Holy cow, indeed. Such a merger would have more drastic consequences to the aviation world as we know it today than the bankruptcy of the American investment banks had in its day. Remember, a few months back even, when Lufthansa, amongst other German carriers, lobbied hard to restrict further access by the Gulf carriers to the German market? And now, it seems, and if we can believe the news article, Lufthansa turned around 180 degrees from its tactics and is in the process of adapting a more pragmatic approach of: if you cannot beat them, join them.

Most of you that know me personally are aware that I am not a friend of market protectionism and that I have lobbied, and will continue to do so, against a strategy of he-has-currently-an-inherit-advantage-in-Porter’s-5-forces-model-so-he-should-be-banned-from-my-play-yard-because-of-unfair-competition. I am a great believer in finding one’s own niche and to continuously adapt one’s business model to continuously changing market conditions rather than focusing one’s already hard-worked resources onto a culture of blame. If and when any entity grows too large to quickly adapt, I would argue that the organization, in its current form, has outlived its useful benefits to society.

Having said this, and I am sure that many of you will not agree with, or even like, my opinion, let’s have an impartial closer look at the article and its potential consequences:

Lufthansa, the former German flag carrier, ranks in the top three of the largest European air carriers and in the top ten world-wide. LH is a member of Star Alliance. With its numerous daughters, such as Swiss, Austrian and Brussels Airlines, it dominates its hubs, such as Frankfurt, Munich, Vienna and Zurich. The company is currently in the process of establishing Eurowings, another daughter that is structured around a low cost business model. The group had a turnover in 2015 of around Euro 32 billion, transported around 107 million passengers, employed around 120,000 staff and operated more than 700 aircraft. In addition to the air transport operations (passenger and dedicated cargo), the group also consists of a number of aviation vendors, such as a large MRO, catering, ICT and training unit. Almost 90% of the group’s turnover stems from European, North-American and Asian-Pacific markets, leaving quite some potential in African, Australian and the Middle Eastern markets. A similar picture emerges when addressing pure cargo income.

Etihad Airways then is the flag carrier of the United Arab Emirates. It was founded 2003 by the emirate of Abu Dhabi in response to the success of Dubai’s Emirates Airlines. It operates 120+ aircraft, transported more than 17 million passengers, employs in excess of 26,000 staff and had an estimated turnover of USD 9 billion in 2015. Etihad’s growth strategy encompasses minority stakes in flailing European carriers, such as Air Berlin and Alitalia. Etihad is not a member of any major alliance and its cargo carried stood at a mere 592,000 tonnes in 2015, standing in stark contrast to Lufthansa’s figure of 1.6 million. Etihad’s only hub is Abu Dhabi International and the carrier serves in excess of 110 destinations.

So, digesting the above preamble, one would say David takes on Goliath once again, wouldn’t one? Well, maybe not. Due to a variety of underlying parameters – and I won’t go into the everlasting discussion of do-they-receive-subsidies-or-not? – certainly a less expensive salary structure, amongst others, the margin of Etihad is much healthier than the one of its European rival. Even without addressing the subsidies question, one does not need to be a rocket scientist to understand that a flag carrier originating an oil-rich home base has certain financial advantages over a competitor that is owned by widely held stock and operates from a diverse economical market.

The gains for both airlines are obvious. So would LH:

1)      improve its balance sheet resulting in serious possibilities to address and counteract rising competition, not only from no-frills airlines such as Ryanair but paradoxically also from direct competitors to Etihad, such as Emirates and Qatar Airways;

2)      gain greater access to mainly Australian and Middle Eastern destinations that currently provide not enough meat to operate as independent routes;

3)      secure yet another customer for its numerous daughters; and

4)      build further on the budding relationship with EY that started with incorporating parts of Air Berlin.

Likewise, Etihad would benefit from a merger by:

1)      participating in decades of solid operational experience;

2)      gaining access to political and slot restricted destinations, including Germany and thus the EU, and as such gain a serious advantage over its political rival up north;

3)      receiving greater influence in regulatory bodies, such as ICAO and IATA; and

4)      exercising an economy of scale approach when negotiating with suppliers, such as OEMs.

Win-win, you say? I would agree but there are always two sides to the coin. After a solid number of years with, call it spectacular for the lack of a better word, growth, recent months have seen the Gulf carriers in a pressure phase that they have encountered for the first time in their relatively short business lives. State households in the Gulf still rely almost exclusively on hydrocarbon revenue and with spot market prices being well below break-even points, many (state owned) projects end-up on the shelves, resulting in fewer business travelers to Gulf destinations, decreasing (state) hotel room occupancy levels and so on. Yes, I know, the Gulf carriers derive their success mostly from the fact that they can easily connect passengers from east to west and vice versa. But even so, modern aircraft are capable to fly further and further and there will be a point in the not too distant future when one can fly from everywhere in Europe and the US to destinations in the Far East, routes that still account for the majority of pax and cargo miles.

Serious and previously unheard of lay-offs of staff at Etihad and Emirates prove the difficult times the carriers face. From the outside, at least, it seems that Etihad’s strategy of buying minority stakes in distressed airlines in order to gain access to their markets does not work as well as planned. We all have heard the rumours that Etihad’s CEO was supposedly on his way out a few weeks back (Update: it seems official as of today. The CEO and CFO of the Etihad Group will leave the corporation mid 2017). And what about the employee turmoil Lufthansa continues to face? The works council of Lufthansa has made it quite clear for a number of years now that it does not accept deteriorating remuneration packages, while Etihad would certainly not accept triple salary levels of its sister.

Of course, both carriers would also need to find a way around the foreign investment regulations in both Germany and the United Arab Emirates. Both countries specify that no foreign entity in its whole may possess more than 49% of a national carrier, a rule that inherently would be broken with a merger between the two carriers. Although I do believe that both corporations employ both the necessary expertise and lobbyists to elegantly circumnavigate such a roadblock, it might be worthwhile remembering that 2017 is an election year in Germany and I do not see any high ranking German politician wanting to burn his or her fingers on such a high profile deal.

So back to square one? Probably, were it not that Etihad has categorically denied the article in the Italian newspaper. And we all have seen where denied rumours can lead to, haven’t we?