ANALYSIS: European airline profits still a work in progress

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Europe’s economy may have lifted from the dog days of the euro crisis and its airlines may collectively be back in profit, but there remains a big difference between thriving and simply surviving.

While passengers have returned, the same cannot be said of yields. It is of course a mixed picture, and airlines have had success in some markets. But plenty in other markets remain under pressure.

The latest Flightglobal/Airline Business World Airline Rankings shows operating profits among the leading European airline groups nearly trebled to a little over $6.2 billion. The figures cover nearly 30 airline groups included in the top 150 airlines by revenue for whom profit figures are available.

But the cost of continued restructuring efforts was felt at a net level as the region’s leading carriers carriers posted $573 million, a little over $200 million up on the same stage in 2012.

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The challenge for Europe’s network carriers is that the competitive pressures that existed before the financial crisis – low-cost carriers eating into their short-haul markets, and the expanding big Gulf three into transfer passengers – is as fierce now as it was before. And their reach has grown.

Mainline passenger numbers among Air France, British Airways, KLM, Iberia and Lufthansa have increased 13 million since 2008, before the financial crisis, to reach just over 200 million last year across the five carriers.

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But over the same period, passenger numbers across the five biggest European LCCs today – EasyJet, Norwegian, Ryanair, Vueling and Wizz Air – increased over 70 million and are now just seven million behind their network peers.

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While the gap may not be so close when the network carrier’s regional and other affiliates are factored in, it does still illustrate the extent to which the fast growth of lower-cost rivals has grabbed short-haul share.

“Even if the LCCs are not taking too much market share away, they [network carriers] are facing pricing pressure,” says Jonathan Kletzel, US transport leader with PwC. This creates a challenge for network carriers to manage capacity.

“Europe is particularly susceptible. There are still a very large number of small carriers that will look for opportunities to take market share, so network carriers there in particular have to manage capacity and defend their share,” he says.

On long-haul, it is the growth of the big Gulf carriers and the equally ambitious and well-located Turkish Airlines that are adding to the competitive pressures. Passenger numbers among these four carriers have doubled since 2008, to almost 124 million last year.

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It is perhaps no surprise that many in Europe have opted to go with the flow of the Gulf carriers, whether through codeshares or even deeper co-operation. Alitalia, close to securing much-needed investment from Etihad, is the latest in Europe to follow such a path.

It means the pressure to restructure in order to compete remains as fierce as ever. It is no coincidence that the airlines to have best weathered the storm are those that have suffered the pain of tackling labour to get a step change in costs, have largely retrenched from non-hub markets and have a strong O&D market. British Airways for example, after cabin crew reforms and with its strong London Heathrow operation, drove IAGs return to profitability last year.

By contrast, its partner in IAG, Iberia, has endured a painful period of losses, suffering from a struggling home market in Spain and a need to push through labour cost restructuring. But the two falling together in such drastic fashion has enabled the airline to secure an almost unprecedented 15% cut in labour costs and a three-year labour peace with salaries tied to performance. This leaves IAG with a foot in the LCC camp as well, through Vueling – with reason for optimism as it hopes to lift operating profits €500 million ($680 million) this year.

Restructuring efforts continue at Air France-KLM and Lufthansa Group, though there is further work ahead for both. Air France-KLM returned to an operating profit last year, and says its Transform efficiency programme is on track, but is looking at further measures and earlier this month cut its full-year profit expectations citing a hit on yields from overcapacity on some long-haul routes and continued weak cargo demand.

The group continues to look at further cuts in its full-freighter business and, amid reports it is looking at the sale of Dutch cargo subsidiary Martinair, says no decisions have yet been taken but all options are on the table. As part of its medium-haul business restructuring, the carrier has cut capacity on point-to-point business but expanded operations of its leisure unit Transavia at Paris Orly airport. Further changes seem likely following a recent review of medium-haul operations which also include the Hop regional unit and the provincial bases concept rolled out two years ago. The airline though has completed the sale of its CityJet unit.

Lufthansa meanwhile finds itself behind plan on its signature Score cost-cutting and revenue-improvement programme. It too has cut its operating profit forecast for the year, pulling it back by €300 million to €1 billion on lower-than-projected sales in its passenger and cargo businesses. Specifically, the carrier cites low ticket prices due to overcapacity in the airline’s main business areas in Europe and on transatlantic routes to North America.

“One of the fundamental problems of Lufthansa is they are increasing the size of their aircraft,” says Shakeel Adam, managing director of consultancy Aviado Partners. “In theory, that means they have a lower unit cost. But that only works if you can fill a bigger aircraft.”

“In this industry supply and demand have to match,” says Adam. “Volumes have been down during the financial crisis and yields have been crashing. You cannot be in the market of pumping out volume in this market.

He says this strategy is at odds with competitors on the North Atlantic. “Everyone else has gone into the market with more flights while Lufthansa is coming in with bigger aircraft. It means their competitors are coming in with smaller aircraft but competitive unit costs.”

Faced with pressure on Asian routes from the Gulf carriers, Lufthansa has opted to deploy much of its capacity on transatlantic services.. “You can understand why they'd pick North America,” says Oliver Sleath, European airlines analyst at Barclays. "That market has consolidated and become very disciplined and probably appeared to have the best chance of absorbing additional capacity. But fundamentally, demand for transatlantic flights is not growing at 7.5%, which is the rate Lufthansa decided to add seats.”

He also believes Lufthansa is growing in a fairly lumpy manner, with extra frequencies or higher-density aircraft being applied across many of its routes. “It’s interesting to note that British Airways, on paper, is growing nearly as fast as Lufthansa to the US this year. But that’s a more balanced approach, including substitute flying for American, new route to Austin, and out of a hub with stronger pricing power [Heathrow]. As a result, BA is able to hold its yields relatively flat.”

Not that its German rival Air Berlin has found it plain sailing even with its new knight in shining armour Etihad. It has been forced back to the drawing board after returning to losses in 2013 and is now having to find deeper cuts. While the Gulf carrier continues to support the airline, it seems clear it is seeking a better return than currently being seen. Its experience in tackling Air Berlin’s challenges also probably explains why Etihad has attached restructuring conditions to any move for Alitalia.

All of which provides more encouragement for Europe’s ever-more-sophisticated low-cost operators that they can take further share. All continue to make inroads not only in new markets outside their traditional bases, but into the business sector. EasyJet turned in improved profits in it last financial year and its first half – during the traditionally loss-making winter season – continued to show improvement.

Ryanair, with its high-profile profit warnings last autumn, created plenty of headlines about its model, but still ended the year with the highest net profit of any European carrier. And amid its continued repositioning, under which it has loosened its grip on its no-nonsense approach to marketing, anticipates higher profits for the year to come.