P&L Check Lufthansa’s Excess Luggage

Germany's flagship carrier has resolved a series of longstanding problems in the past year, but its costs remain too high to cope with growing competition.
It costs too much to fly this plane. Sven Hoppe / DPA

It's been a good 12 months for Carsten Spohr. Lufthansa's chief executive has sorted out a string of problems over the last year and will be able to deliver a raft of good news to shareholders during Friday’s annual general meeting.

He’s settled longstanding and crippling pay disputes with cabin crew and pilots, and has paved the way for growth for its budget unit Eurowings, which is to be merged with the newly acquired Brussels Airlines. He has also leased 38 aircraft complete with crew from struggling rival Air Berlin.

The return to strength is reflected in the 2016 results of Germany’s national carrier, Europe’s largest in terms of revenue. Group net profit rose 4.6 percent to €1.78 billion, or $1.94 billion, on revenue down slightly by 1.2 percent to €31.7 billion. That’s a sign that Lufthansa is managing to cut costs. Its labor costs fell by 8.9 percent to €7.35 billion thanks in part to a deal with cabin crew that has lessened the airline’s pension costs.

But Handelsblatt’s P&L check shows that Mr. Spohr, an engineer with a pilot’s license, still faces tough challenges. Lufthansa’s costs remain too high in comparison with prominent competitors. Its operating margin in 2016 was 7.1 percent. By contrast, the margin of its British-Spanish rival IAG, which owns British Airways, was 11.23 percent. Emirates and the big US airlines also achieved double-digit margins.

Ryanair beat Lufthansa to the title of Europe’s largest airline in terms of passenger numbers last year.

The Cologne-based carrier, which also owns the brands Swiss and Austrian, has to bring down costs to compete effectively with state-backed airlines such as Emirates and Qatar Airlines as well as low-cost rivals like Ryanair, Easyjet and Vueling.  Ryanair beat Lufthansa to the title of Europe’s largest airline in terms of passenger numbers last year, although the German airline still remains the largest in revenue. Lufthansa has more to lose if Mr. Sphor, 50, fails to address rising competition.

A close look at the numbers shows how far the executive still has to go to reduce spending. Part of Lufthansa’s earnings improvement last year stemmed from a decline in fuel prices, which boosted earnings by €899 million. Lufthansa’s unit costs, defined as costs per available seat-kilometer, a key figure in the airline industry, fell by 3.2 percent. That drop, however, was not nearly enough to counteract the drop in revenue per seat-kilometer, which fell by 5.8 percent as a result of tough price competition.

In the first quarter of 2017, unit costs even rose again, by 1.4 percent. The rise was attributed to one-off effects, but Chief Financial Officer Ulrik Svensson nevertheless called it a “disappointment.” Those costs are partly caused by flight charges that are beyond Lufthansa’s control and which account for the largest cost items in Lufthansa’s passenger business.

The airline is battling to reduce these costs and Germany’s air traffic control company, DFS, has reduced its fees of late. Lufthansa is also in talks with Fraport, the company that manages its main hub at Frankfurt airport, about reducing costs. Fraport recently provided discounts to budget airline Ryanair.

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Lufthansa’s problems do not just stem from labor costs, which rank as the third-largest cost item behind charges and fuel. Sifting through the results, however, it’s hard to make this differentiation, because the airline doesn’t separately list outlays for marketing or administration.

But if you talk to Lufthansa executives, you keep hearing complaints that the organization is too complex. In early 2016, Mr. Spohr introduced a matrix management structure developed by McKinsey. Since then, the management of Lufthansa’s subsidiary Swiss in Zurich has also been responsible for the revenue management of all premium brands, including Austrian and Lufthansa Klassik. Responsibility for production is based in Vienna, distribution in Frankfurt and marketing in Munich.

The aim is to speed up decision-making. For instance, a new airline seat is no longer developed at four different sites by four different teams, as was the case before. Now, it’s only developed in Vienna. So the new structure does have its advantages. Mr. Svensson, the head of finance, has promised that the reorganization will lead to savings of €500 million by 2019.

But insiders are complaining that Lufthansa lacks a strong leader to breathe life into the matrix, to pull all the strings and guide the complex network. At present, Lufthansa employees and executives are flying back and forth between four new competence centers, which is inefficient, they say.

Some believe a holding company structure would better suit a firm with as many subsidiaries and brands as Lufthansa.

In addition to its cost structure, Lufthansa has had to worry about its blue-chip DAX listing. Its share price performance was disappointing last year, falling 15.8 percent while the DAX index of 30 leading shares rose almost 7 percent.

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Lufthansa keeps saying the airline is undervalued and points to the €17 billion book value of its aircraft, which dwarfs Lufthansa's current market value of €7.5 billion. But evidently, the stock isn’t particularly attractive to investors.

That means Lufthansa may be evicted from the DAX index of most valuable and heavily traded stocks. So far, it has managed to remain thanks to the high trading volume of Lufthansa shares. An eviction would hurt its image and could lead to further share price drops as index tracker funds, which account for much of the turnover in its shares, would immediately ditch the stock.

Mr. Spohr, however, can turn the airline if his new strategy of cutting costs and lifting profitability pays off. His head of finance head, Mr. Svensson, has implicitly acknowledged this. “When it comes to reducing costs, we still have some work to do,” he said recently.

 

Jens Koenen leads Handelsblatt's coverage of the aviation and space industry. To contact the author: [email protected]