Aviation Economics James House, LG2, 22/24 Corsham Street London N1 6DR Tel: +44 (0) 20 7490 5215 Fax: +44 (0) 20 7490 5218 e-mail: [email protected]Issue No: 86 December 2004 Aviation Strategy Analysis European LCC bankruptcies 1-2 Aer Lingus: political procrastination 2-4 The case for investing in airports 4-6 Asia/Pacific airlines 6-7 Continental: lessons in labour negotiation 8-11 Opportunities at Chicago Midway 12-14 Briefing Air Berlin battles through Germany’s LCC wars 15-19 Databases 20-23 Airline traffic and financials Regional trends Orders CONTENTS PUBLISHER www.aviationeconomics.com European LCCs: Is this the "bloodbath"? T he hyperbolic prediction earlier this year by Ryanair CEO Michael O'Leary that there would be a "bloodbath" in the European LCC sec- tor this winter has had the desired effect of unnerving LCC investors. Partly as a consequence, several of the weaker LCCs have gone bank- rupt; others will follow. The most recent casualty is Warsaw-based LCC Air Polonia, which suspended flights in early December and as Aviation Strategy went to press was urgently searching for a new injection of funds from either LOT or private investors. Air Polonia ran into trouble after it couldn't afford a $800,000 instalment on the lease of its aircraft, followed by the collapse of a planned €10m loan from an existing Irish investor group. The airline is believed to have debts of around €7m. Air Polonia was launched as a charter carrier in 2001 but adopted an LCC business model in December 2003. It operated three 737s, three Let L410s and an An-28 on routes from six Polish cities to secondary airports in five European countries, including London Stansted and Paris Beauvais. Air Polonia's demise represents a rationalisation of the east/central European LCC market where three players - Air Polonia, Wizz Air and SkyEurope - were at least one too many. Hungarian/Polish airline Wizz now appears to be safe following an injection of €25m from US investor Indigo Partners. Wizz Air operates six A320s on services across Europe, and is now planning a major expansion in 2005, with 10 new routes from Budapest, Katowice and Gdansk. Air Polonia also wasn't helped by the problems of alliance partner Volare, the Italian group that includes LCC Volareweb.com and charter carrier Air Europe. The Milan-based Volare Group has 1,400 employees and was founded back in 1994, and its LCC subsidiary operated 17 A320s to France, Spain, the UK, Germany and Belgium. The group declared itself insolvent at the end of November after it couldn't pay lease fees, its debt reached the dizzy heights of €300m and attempts to find emergency funding of €60m failed. Volare chairman Mauro Gambaro wants the government to bail out the group but, ironical- ly, Italian law prohibits the state from bailing out troubled companies unless their debt reaches €1bn. To make matters worse, in November Italian prosecutors began infor- mal questioning of Andrea Molinari, Volare's former CEO, about potential false accounting and misuse of funds at the group, although no charges have yet been laid. Apparently Deloitte & Touche claim they warned Volare about the precarious nature of its finances as early as 2002. Volare is owned 39% by Argentinean businessman Eduardo Eurnekian and 25% by Ginni Zoccai, former president of Volare. Eurnekian has reportedly agreed an option to buy Zoccai's stake in March 2007 for €35m, though unless there is a bailout and a remarkable turnaround the option will be worthless.
European LCCs: Is this the "bloodbath"?The hyperbolic prediction earlier this year by Ryanair CEO Michael
O'Leary that there would be a "bloodbath" in the European LCC sec-tor this winter has had the desired effect of unnerving LCC investors.Partly as a consequence, several of the weaker LCCs have gone bank-rupt; others will follow.
The most recent casualty is Warsaw-based LCC Air Polonia, whichsuspended flights in early December and as Aviation Strategy went topress was urgently searching for a new injection of funds from either LOTor private investors. Air Polonia ran into trouble after it couldn't afford a$800,000 instalment on the lease of its aircraft, followed by the collapse ofa planned €10m loan from an existing Irish investor group. The airline isbelieved to have debts of around €7m.
Air Polonia was launched as a charter carrier in 2001 but adopted anLCC business model in December 2003. It operated three 737s, three LetL410s and an An-28 on routes from six Polish cities to secondary airportsin five European countries, including London Stansted and ParisBeauvais.
Air Polonia's demise represents a rationalisation of the east/centralEuropean LCC market where three players - Air Polonia, Wizz Air andSkyEurope - were at least one too many. Hungarian/Polish airline Wizznow appears to be safe following an injection of €25m from US investorIndigo Partners. Wizz Air operates six A320s on services across Europe,and is now planning a major expansion in 2005, with 10 new routes fromBudapest, Katowice and Gdansk.
Air Polonia also wasn't helped by the problems of alliance partnerVolare, the Italian group that includes LCC Volareweb.com and chartercarrier Air Europe. The Milan-based Volare Group has 1,400 employeesand was founded back in 1994, and its LCC subsidiary operated 17 A320sto France, Spain, the UK, Germany and Belgium.
The group declared itself insolvent at the end of November after itcouldn't pay lease fees, its debt reached the dizzy heights of €300m andattempts to find emergency funding of €60m failed. Volare chairmanMauro Gambaro wants the government to bail out the group but, ironical-ly, Italian law prohibits the state from bailing out troubled companies unlesstheir debt reaches €1bn.
To make matters worse, in November Italian prosecutors began infor-mal questioning of Andrea Molinari, Volare's former CEO, about potentialfalse accounting and misuse of funds at the group, although no chargeshave yet been laid. Apparently Deloitte & Touche claim they warned Volareabout the precarious nature of its finances as early as 2002. Volare isowned 39% by Argentinean businessman Eduardo Eurnekian and 25% byGinni Zoccai, former president of Volare. Eurnekian has reportedly agreedan option to buy Zoccai's stake in March 2007 for €35m, though unlessthere is a bailout and a remarkable turnaround the option will be worthless.
Aviation Strategy
Analysis
2
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December 2004
The government has appointed an adminis-trator, Carlo Rinaldi, to try and rescue the group,and he attempted to put together a rescue planfor the Italian civil aviation authority by a deadlineof December 10. On that day the CAA stated arescue plan had been submitted by Volare, butthat it lacked sufficient detail on finances.However, the CAA gave Volare one last chance,by extending the deadline to December 15. If arescue plan is approved, Volare flights willresume for the Christmas and New Year period,but if it isn't accepted by the CAA, then other air-lines could be authorised to take over Volare'sroutes.
In late October, Dutch LCC V Bird went bank-rupt owing around €39m to creditors. The airlinewas launched by Dutch and US investors (includ-ing former Air Exel chief Roberto Stinga) inOctober 2003, but collapsed after the ExelAviation Group reportedly declined to inject fur-ther funds to save the airline.
V Bird employed 190 people and operated afleet of three A320s - leased from ILFC - to 17destinations in Europe. V Bird's main hub was atNiederrhein, a former military airport based justover the border in Germany, and it flew around700,000 passengers in 2004 before collapsing,claiming a load factor of more than 70%. Talkswith potential rescuers for V Bird appear to havepetered out, and Germanwings is in negotiationswith ILFC to take over V Bird's leases.
V Bird had hoped to establish itself as a
European version of JetBlue, but never achievedmuch of a profile, blamed on lack of an advertis-ing budget but probably also related to the unat-tractiveness of its airport base.
A putative long-haul LCC has also failed -Civair which was to have flown 747s betweenLondon Stansted and South Africa did not start upin early December as planned, following the with-drawal of backers.
easyJet/Ryanair:expansion and cashflow
Rationalisation through bankruptcy is a rapidprocess in Europe, the reverse of the explosion ofLCCs many of which, though not all, had weakbusiness plans and/or were underfunded. ForeasyJet and Ryanair, the development is wel-come - they will need the space to expand into asthey continue to take two or so new aircraft amonth (see Aviation Strategy, June 2004). Theirexpansion has now taken on a momentum of itsown through their sale and leaseback activity: asaircraft are delivered these LCCs have the oppor-tunity of monetising the deep discounts theyreceived from Airbus and Boeing, by selling theaircraft at market values to leasing companiesthen leasing them back; in other words, each air-craft delivery potentially boosts the airlines' cash-flow.
The sudden resignation of the highlyregarded and successful top manage-
ment team at Aer Lingus, the Irish state-owned airline, raises a number of questionsabout the role of the Irish government withregard to the most financially successful ofthe AEA airlines.
The decision of Chief Executive WillieWalsh, Financial Director Brian Dunne andChief Operating Officer Seamus Kearney tojump ship is a clear indication of frustration atthe Irish government's continuing delay inimplementing its commitment to privatisationmade as far back as December 1999. It alsoreflects management's perception of less
than full-hearted shareholder support for itslatest cost reduction plan which calls for a fur-ther loss of 1,325 jobs (on top of 2,000-plusjobs shed over the last two years thus reduc-ing employment by over 50% since 2001).This would involve an increased level of out-sourcing, which is anathema to the unions,which are regarded as social partners by thegovernment.
Over the last decade the government'sposition on state ownership of Aer Lingus haswaxed and waned, influenced by politicalexpedience rather than the needs of the air-line or the management's views. Here is apotted history.
Aer Lingus: the effect of government indecision and procrastination
• Since the mid 1960s, when a minority share-holding held by BEA was acquired, the Irishstate has been the 100% shareholder in AerLingus.• Following the worldwide recession in theearly 1990s the airline undertook a majorrestructuring programme involving consider-able staff and other cost reductions, a dispos-al plan for non-airline subsidiaries and a stateaid last time equity injection of IR£175m($120m). In return for cooperation on therestructuring plan staff were granted accessto a 5% shareholding in 1995.• In autumn 1997 the government directedmanagement to begin a competitive processto find a strategic alliance partner with or with-out an equity element. This was clearly inter-preted as an initial key step towards privatisa-tion although the government was not pre-pared to acknowledge this publicly for politicalreasons.• Political indecision, the requirement to con-vince the unions of the benefits of a strategicalliance together with top managementchanges at the airline led to a long drawn-outprocess which was not completed until mid1999. Bilateral alliances were signed withboth American Airlines and British Airways(leading to membership of the oneworldalliance in 2000). An equity element was pro-posed but this was not acceptable to the gov-ernment or unions.• In December 1999 the government eventu-ally made a commitment to privatise AerLingus. This was to be in the form of an InitialPublic Offering (IPO) and good progress wasmade in the preparations necessary for apublic flotation of shares in the airline. Thelegislation passed all stages in the Seanad(senate or lower house) and discussionsbegan with staff representatives on the struc-ture of Employee Share Option Scheme(ESOP) which would be part of the IPO.• Discussions between the government andstaff representatives proved to be long anddifficult and little progress was made over anumber of months. Management was effec-tively sidelined during this process, which ledto a fair measure of frustration.• By mid-2000, market conditions for IPOshad deteriorated and the government nowasked its advisers to look at alternative saleoptions for the airline, thus adding further
delay to the sale process. Not surprisingly, theadvisers found a considerable degree of inter-est from potential institutional and privateinvestors but this only led to further procrasti-nation by the government.• By summer 2001 management had lost faithin the government's privatisation intentions,and several senior executives decided tomove on or retire. Then came the September11 catastrophe, the Aer Lingus survival planand the appointment of Willie Walsh as chiefexecutive.• The successful implementation of the sur-vival plan by Walsh, Dunne and Kearney andfurther radical restructuring over the last twoyears was detailed in the July/August editionof Aviation Strategy. Aer Lingus is forecast torecord profits in excess of €100m this yearand a profit margin over 10%, the highest ofall of the AEA airlines.• Management and shareholder are agreedthat the airline needs access to equity fundingto strengthen the balance sheet and toexpand and replace the long haul fleet.Government policy is not to invest further inthe airline yet, despite a renewed undertakingto the airline Board and management inSeptember 2003 by the Minister of Transportthat the ownership issue would immediatelybe addressed, no decision has been taken todate.• Increasing frustration at government's inac-tion prompted the management trio in June toformally request permission to develop aninvestment proposal for the airline. This wasinterpreted by many as a potential MBOrequest. Whatever, it was clearly designed toforce a decision from government on the own-ership/funding issues.• The government responded by setting up aCabinet sub-committee to consider the futureof Aer Lingus. It then appointed GoldmanSachs to report on the strategic issues andoptions to be considered in the context ofownership change. Although that report hasbeen with government for some months, ithas not been published nor been addressedto date by the Cabinet sub-committee. • The government, however, did set up anESOP this summer. Staff now have a 14.9%shareholding in the airline.• Negative feedback on government's attitudeto management and its further restructuring
Aviation Strategy
Analysis
December 20043
The case for investing in airports stillremains a strong one. They promise long-
term volume growth and typically have lowcash flow and low earnings volatility. At therecent Global Airport Development confer-ence held in Prague, the state of the sectorand investment cases were discussed.
Airports are regulated monopolies withrobust EBITDA margins, which have in mostcases withstood external pressures likeSeptember 11, SARS and even the demise offlag carriers (for example Sabena atBrussels). At successful airports, non-aero-nautical revenues typically grow at twice therate of the regulated aeronautical revenues.Within the sector it is clear that there is a dif-ference of emphasis between the investmentmodels of the key investors - airports andfinancial buyers.
Airport operator investment model
The major airport operators (BAA, Fraport,
Vienna International, Copenhagen Airportsand TBI) have had their appetites for invest-ments somewhat reduced post September11. It has been a period where the airportshave had to concentrate on cost cutting anddeal with increased security requirements.Also, shareholders have shown a lukewarmreaction to investments made by airport oper-ators where they have been unable to securea controlling stake and have historicallyunderestimated the political risk involved (forexample, Fraport's investment in Manila,where contractual disputes culminated in amult-million dollar loss for Fraport).Copenhagen Airports is still receiving criticismfor its 49% investment in Newcastle Airport,which cost Copenhagen £95m in May of2001, at the time that was a hefty 18.5 timesEBITDA.
BAA makes as much money from theHeathrow Express (an express rail link serv-ing the airport and central London) as it doesfrom its total airport investments inMelbourne, Perth and Naples. These airportinvestments account for only 2% of BAA's
Aviation Strategy
Analysis
December 2004
The case forinvesting in airports
4
plans (particularly relating to outsourcing) ledto management withdrawing its request forpermission to develop an investment propos-al at the end of October and this was followedsome two weeks later by the resignationannouncement by Walsh, Dunne andKearney. The loss of the three executives,widely acknowledged as responsible for oneof the most successful turnarounds in airlinehistory, leaves the future of Aer Lingus insome disarray. Although the trio have offeredto stay on board until the and of May nextyear their potential effectiveness in managingthe airline, not to mention delivering furthertransformation, must be in serious doubt par-ticularly in the light of the Taoiseach's (PrimeMinister) recent comments to the Dail(Parliament) where he clearly sided withunion resistance and criticised the manage-ment for their personal ambitions of wealthfrom the sale of a state asset. Although Walsh
has robustly rejected this criticism, the dam-age has been done. Rumours are that Walshwill resurface next year as the chief executiveof a leading LCC.• Another issue is that the Aer Lingus chair-man Tom Mulcahy resigned this summer.John Sharman was appointed acting chair-man initially for a three-week period but laterextended until the end of 2004, after a num-ber of prominent Irish businessmen turneddown the chairmanship. Thus Aer Lingustoday has a lame-duck management and atemporary chairman. • Latest reports from reliable sources inDublin suggest that a decision will be madebefore Christmas to float 51% of Aer Lingusshares. That decision however will not beacted on until a new chief executive is inplace and market conditions are favourable -so yet more delays.
group pre-tax profits. Few airports also havemajor free cash flow to invest; for example,BAA's gearing will rise to around 50% at thepeak of its investment in Heathrow's Terminal5. Rather than just bricks and mortar, BAA ishappy to expand its international activitiesthrough retail contracts, where there hasbeen no equity investment but an upsidepoptential through profit sharing.
However, activity in the airport sector isresuming again, reflecting the general upturnin aviation. Recently, Abertis, the Spanish tollroad group and AENA, the Spanish airportsauthority, have acquired 29.9% of TBI andhave binding offers for another 19.5% of theshares. Last month, Macquarie Airportsacquired a 70% equity interest of BrusselsZaventem airport for €735m ($953m) from theBelgian state-run BIAC and a number of othershareholders .
Macquarie Airports: the financial investment model
Macquarie Airports, a listed globally diver-sified airport fund, looks to invest in devel-oped assets. They focus on dominant airportswithin a strong catchment area, airports withabove average traffic growth and strongEBITDA margins. Also crucial for the invest-ment case is a strong commercial upside,light-handed regulation at the airport andpreferably no large future capex programme.Macquarie has expertise in financial restruc-turing rather than managing, they prefer toapply their aviation knowledge as a share-
holder not a manager and so unlike an airportoperator there are no management fees.Their skill lies in managing the airport's capi-tal base and using sophisticated financialinstruments to fund new acquisitions or to re-finance existing debt (which Macquarie ispreparing to do at Bristol Airport).
Macquarie prefers to apply their aviationexpertise as a shareholder rather than as amanager, this tactic seems to be paying off.The Macquarie Airports fund is now trading at14 times EBITDA, while the averageEV/EBITDA of the quoted European airportsector is currently at around 8.
The future
The sellers, which are usually govern-ments, are becoming increasingly sophisticat-ed in how they sell their airport assets andcompetitive auctions are producing highprices. In Europe, Budapest Ferihegy Airporthas issued a tender publication for a privati-sation adviser and Aeroports de Paris are inthe initial stages of restructuring ahead of aplanned privatisation (the French governmenthowever are set to retain a majority stake).
Determining who will be the winnersand losers is becoming harder in this morecomplicated investment environment. InEurope, it is clear that three super-hubs(Heathrow, Charles de Gaulle and Frankfurt)have true pricing power and our set to domi-nate. It is less clear whether any of the mini-hubs will make good investments. Take forexample, the case of both Prague and
Aviation Strategy
Analysis
December 20045
International
hubs
Atlanta
79m pax
• High share of transfer traffic • Large catchment area • Pax in excess of 40m
• Main hub of major international airline • Leadership role in alliance
18
International O and Ds
Sydney 22m pax
• Lower share of transfer traffic • Large catchment area • Pax in excess of 20m
• Main hub of int’l long haul airline or secondary hub of major airline • Subordinate or niche player in alliance
32
Secondary hubs and O and Ds
Vienna
12m pax
• Low share of transfer traffic • Sizeable catchment area, often overlapping • Pax around 10m
• Main hub of regional airline or secondary hub of major airline • Subordinate role in alliance
c. 150
Regionals
Albany International
Airport 1.5m pax
• No transfer traffic • Smaller or remote catchment areas • Pax below 10m
• Regional airlines • LCCs
c. 2,400
No. ofairportsAirlineKey CharacteristicsExample
AIRPORTS: THE FOUR DIVISIONS
Source: Boston Consulting Group
In a recent research note by DeutscheBank it is reported that the global airline
industry will likely lose (according to IATA)over $3bn this year, due largely to escalatingfuel prices. This comes as no surprise, but it
is important to separate the Asian carriers,which are seeing some of the most robusttravel demand in years, from the US andEuropean carriers, which continue to faceyield pressures and are operating on thinnermargins. Most major Asian airlines willremain profitable in 2004.
Cathay PacificDeutsche Bank forecasts Cathay’s net
profit for the 2004 financial year at aroundHK$3.7bn ($480m) with the 2005 forecastcoming in at HK$4.8bn. The bank assumesthat passenger yields will rise 6.8% year-on-year in the 2004 financial year. From thisassumed profit base of HK$3.7bn, there isnow upside surprise potential, as yieldsand/or surcharges could come in strongerthan expected.
Korean AirThe 2004 financial year forecast for net
profits was W51bn ($48m) and net profits for
Aviation Strategy
Analysis
December 2004
Robust resultsin Asia/Pacific region
6
-15-10-505
101520
2000 2001 2002 2003 2004E 2005E
% KOREAN AIR
05
1015202530
2000 2001 2002 2003 2004E 2005E
% CATHAY PACIFICOp.
margin
Netmargin
Budapest airports, both slated for future pri-vatisation and both are keen to challengeVienna as the hub for eastern Europe. But,Prague and Budapest have much less pricingpower and often need to discount to attractpassengers, a situation that is comparable tothe contrast between Frankfurt and Frankfurt-Hahn airports.
Schiphol Airport is also facing some uncer-tainty regarding the dual-hub strategy thathas been implemented following the AirFrance/KLM merger. Schiphol’s future issecure, at least for the next five years accord-ing to the merger terms, however investorswill tread warily over the future of the weakerhub.
Other challenges facing airport investorsare the instability of traffic flows, in the UShubs are collapsing and in Europe flag carri-ers, such as Swissair and Sabena, havefailed. Also, historic travel patterns are being
challenged by the LCCs. At regional airports,LCC growth is now typically growing ten timesfaster than the legacy carriers. In Germany,hubs such as Frankfurt and Munich recordedhigh growth rates for 2003 and the earlymonths of 2004, however the most dramaticgrowth rates came from regional hubs boost-ed by the LCCs such as Berlin Schonefeld,Frankfurt-Hahn, Nurenburg and Stuttgart.
At the same time, investors will have totake a view on the survival of core carriers.Prague Airport is served by 14 LCCs momen-tarily, the figure was 15 before the recent col-lapse of Volare. However, there have been 20LCC failures in the last two years.
Added to this volatility, future travel pat-terns are likely to be distorted by the arrival ofnew aircraft types. The A380 will be good forsuper-hubs but Boeing's 7E7 will suit smallerhubs and larger regional airports.
2005 were forecast at W143bn. These fore-casts reflect higher fuel price assumptions,which are partially offset by assumed higheryields. Passenger and cargo yield assump-tions for the 2004 financial year were raisedby 1% in November, and Korean Air isexpected to make a small profit of W72bn inthe second half of 2004 (versus a W22bnloss in the first half of 2004).
Malaysia AirlinesMalaysia Airlines still looks likely to
record a small net profit of around RM29m($7m) for 2005, compared to 2004’sRM481m ($126m). The airline's overall traf-fic growth looks healthy and Deutsche Bankforecasts a RPK growth of 20% for the 2005financial year. however the net financialresult will be close to break-even.
Qantas Airways Ltd.Excellent hedging, fuel surcharges and
the rising strength of the Australian dollar areall mitigating the fuel price impact for Qantasin the 2005 financial year. Despite domesticyield pressure, a net profit of A$765m($573m) is forecast for 2005, compared tothe announced A$648m in 2004. Thisexpected strong result is also due to improv-ing yields and strong growth in its interna-tional business.
fuel prices, SIA net profits are forecast atS$1,041m ($632m) for 2005 against 2004’sS$849m. Cargo yields grew 7% for the sec-ond quarter 2005 over the first quarter withpassenger yields three points up, suggestingthat fare hikes and surcharges are beingpassed through. With better hedging the fuelexpense was lower than Deutsche Bank hadexpected.
Virgin Blue HoldingsVirgin Blue is forecast to make a net prof-
it of A$165m ($125m) in the financial year2004/05 and A$200m in 2005/06. The cur-
rent leisure focus of Virgin Blue makes itmore difficult to pass on rising fuel costs topassengers via surcharges than for Qantas,leaving it at some risk. Also, higher thanexpected domestic yield pressure is affect-ing Virgin Blue as well as Qantas.
Aviation Strategy
Analysis
December 20047
-15
-10-5
0
510
15
2000 2001 2002 2003 2004 2005E
% MALAYSIA AIRLINES
0
5
10
15
20
25
2000/01 2001/02 2002/03 2003/04 2004/05E 2005/06E
QANTAS%
05
1015202530
2000 2001 2002 2003 2004 2005E
-20
-10
0
10
20
30
2000/01 2001/02 2002/03 2003/04 2004/05E 2005/06E
% SINGAPORE AIRLINES
% VIRGIN BLUE
Op.margin
Netmargin
In late November Continental became thelast of the top six US legacy carriers to seek
wage concessions in the post-September 11environment. The airline announced that itwould begin "accelerated discussions" with itswork groups to achieve a $500m reduction inits annual payroll and benefit costs by the endof February. This would be in addition to thepreviously announced target of $1.1bn annu-al cost savings and revenue enhancements.
The move obviously reflects worsenedindustry fundamentals (oil and the domesticrevenue environment), continued significantfinancial losses and fears of a liquidity crunchthis winter. However, aside from that, it isprobably the best piece of news that hasemerged from the legacy carrier camp inrecent memory.
This is because Continental is expected tosucceed in its efforts (though some analystsdoubt it will meet the February 28 target date).Securing wage cuts is never easy, but theHouston-based carrier should be able toaccomplish it without too much acrimony, per-haps even teaching the industry a fewlessons about post-2001 labour negotiation.
It would certainly contrast with the latestdevelopments at United and US Airways -both are now seeking approval in bankruptcycourt to terminate labour contracts, whilesome of their unions are preparing for it by
sending out strike ballots. This is the first timethat substantive strike talk has surfaced sinceSeptember 11.
Most significantly, however, wage cuts atContinental should put considerable pressureon American and Northwest - and probablymake it easier for both - to secure the addi-tional cost cuts that they need. Overall, theodds now seem higher that the currently sol-vent legacy carriers will attain competitivecost structures outside of Chapter 11.
In the first place, Continental is likely tosucceed because of its amicable labour rela-tions. As testimony to that, in September theairline signed what it described as an"unprecedented partnership accord" with itsALPA-represented pilots. The deal formaliseda commitment to work together and seekcommon solutions through a difficult industryclimate. It was a culmination of more than ayear's efforts to "develop a relationship basedon providing each other with accurate, factualinformation and considering each other'sinput regarding operational and other issues".The process has already helped resolvesome important issues, including the recentrecall of 310 furloughed pilots "without impos-ing burdensome costs on the carrier".
Ironically, Continental is relatively healthynow only because it sought extensive helpfrom Chapter 11 in the past. In chairman/CEOGordon Bethune's words, it was a "goodexample of a company that ripped its labourcontracts and stiffed its creditors" in the mid-1980s (under Frank Lorenzo's rule) and whilein Chapter 11 again in 1990-93. (Lorenzo'slabour moves were so abhorrent that theyactually led to the revision of the Chapter 11code, making it tougher for companies to ter-minate labour contracts in bankruptcy.)
Continental emerged from Chapter 11 inApril 1993 with low unit costs but rock-bottommorale. However, Bethune, who is retiring atyear-end, made improving employee rela-tions and the corporate culture his prioritythroughout his ten-year tenure.
Aviation Strategy
Analysis
December 20048
Lessons in labour negotiation from Continental
8
9
10
11
12
Continen
tal
America
nUnite
d
Northwest
Delta
US Airw
ays
Source: Calyon Securities
UScTHE LEGACY CARRIERS’
COSTS PER ASM
3Q2003
3Q2004
The key part of the process was to gradu-ally restore wages to industry standards(achieved by the turn of the decade), whilemaintaining the productivity advantagesestablished in Chapter 11. It was a feat to staydisciplined with the wage-restoration processin the late 1990s, when United allowed itslabour costs to soar and other legacy carriersfollowed suit.
It has been suggested that Continentalmay be rushing the start of the wage conces-sion talks so that popular CEO Bethune canplay a role in the process before Larry Kellnertakes over. One analyst argued that it mighthave been better for Kellner to spend his ini-tial months "building new bridges with labour".However, Kellner is a well-established mem-ber of the top management team and thebridges with labour may already be there.
If the management and the pilots (the keygroup) stick to the provisions of theSeptember accord, and if Continental gen-uinely needs the wage concessions (meaningit can prove the need), the odds are for a suc-cessful outcome. The deal addressed labourunions' traditional grievances fairly compre-hensively, emphasising trust, mutual respect,proper documentation and open and honestcommunication. It also formalised the pilots'requirement for a "fair share" of financialrewards when the airline returns to profitabili-ty. The union also agreed to "temper our com-munications". When the deal was signed,ALPA's president Duane Woerth suggestedthat it could be a model for the industry.
Explaining the key concepts at a recentconference, Bethune noted that "it is alwaysdifficult to ask people for money, but if youhave it well documented, it means you're notguessing". He emphasised that it is importantto do it only once, rather than keep goingback to ask for more (like US Airways andUnited have done). Bethune also made thepoint that it takes years to build trust.
One particularly nice aspect ofContinental's move is that the top manage-ment will take the lead in pay reductions.Kellner will take a 25% cut in salary and per-formance compensation, and four other topexecutives will take 20% cuts, effective fromFebruary 28.
The company expects about half of the
$500m savings to come from productivityenhancements and benefit changes and theother half from wage rate cuts. The latterwould be on a progressive scale, with lower-paid employees being asked for a lesseramount. There would be enhanced profitsharing and continuation of on-time perfor-mance and other incentive programmes.
Potential liquidity issues
Continental is in no immediate danger ofbankruptcy. Its financial results have consis-tently been better than those of its legacypeers, as it has outperformed the industry onboth the revenue and cost fronts. Its CASM,at 9.35 cents per ASM in the third quarter, isthe lowest among the large network carriers.Remarkably, its quarterly cash position hasremained virtually unchanged (in the $1.5-1.6bn range) in recent years - a reflection ofstrong financial management. It still expectsto end the year with $1.4-1.5bn of unrestrict-ed cash - and it still holds a sizable stake inregional carrier ExpressJet that could bemonetised.
However, Continental is meeting its liquid-ity targets only because it missed a $245mpension payment in September, and becauseit is collecting $80m from the disposition of itsOrbitz holdings in the current quarter. Missingthe pension payment was totally legitimate -the company took advantage of the tempo-rary relief provided by Congress in April,which allowed airlines to delay some of theirnear-term pension obligations. Continentalstill intends to keep its plan up to 90% fundedon a current liability basis; instead of paying$245m in September and $40m in 2005, it willnow pay around $300m in 2005.
Continental may not be able to maintainsatisfactory liquidity through the weakest partof the winter in the current fuel and fare envi-ronment, and selling the ExpressJet stake isprobably being kept as an emergency optionor "plan B".
But even if liquidity does not become anissue this winter, Continental needs labourconcessions to avoid losing its competitiveadvantage. It is clear that United's and USAirways' cost cuts in Chapter 11, as well as
Aviation Strategy
Analysis
December 20049
the concessions American obtained on thecourthouse steps in spring 2003, have nar-rowed the labour cost gap. In any case, all ofContinental's three major union contractsare now amendable, meaning that negotia-tions would take place anyway.
More clarity about wage benchmarks
Until recently, the big frustration forContinental was that it could see competitorsgaining ground on the labour cost front but itdid not know where the process would stop.The goal posts have been shifting continu-ously since September 11. The airline waswaiting for more clarity before responding,because it is determined to make wage con-cessions a one-time event.
The decision to seek $500m of labourconcessions means that Continental feelsthat there is finally some level of clarity as towhere the new wage benchmarks might be.However, it was a little disconcerting to seeBethune also note in the press release that"competitive financial analysis would supportour asking for substantially larger reduc-tions" (though that remark was obviouslymeant for employees).
The following is a summary of the keylabour developments at the other large lega-cy carriers:
United is the airline everyone, includingContinental, is really watching. It was theone that raised the bar for the rest of theindustry in 2000 - not just in terms of pilotpay but right across employee groups - andit now has to lower the bar. Having been inChapter 11 since December 2002, United istrying to prepare for a successful (much-delayed) exit from bankruptcy in 2005. Afteralready shaving $5bn from its annualexpenses, the airline says that it needs $2bnmore to secure exit-financing and long-termsurvival.
The $2bn cuts would come from addition-al labour concessions ($725m), terminationof pension plans ($650m) and non-laboursources ($655m). Of the $725m labour total,pilots would contribute $191.2m, machinists
$180m, flight attendants $137.6m andsalaried workers and management $111.8m.
Consequently, United is in the middle ofits second round of labour concession talks.Having already agreed to $2.56bn of give-backs, the unions have not responded well.There was a watershed development onNovember 24, when United filed a Section1113 motion, asking for permission to rejectunion contracts if consensual agreementson the $725m cuts have not been securedby mid-January. Significantly, the judgeagreed to consider the motion, scheduling ahearing on it for January 10. United is alsoseeking a 4% company-wide pay reductionfrom January 1 until Chapter 11 exit.
The impression gained is that it wasessentially the substantial size of United'sproposed cuts and the Section 1113 filingthat clarified the situation enough andprompted Continental to act (to the extentthat it is responding to competitors' moves).
As regards to pilot pay, competitors cannow easily calculate the new benchmark.United's pilots first took a 30% pay cut; nowthey will see a further 18% reduction - eithera straight pay cut or a combination of payreduction and work rule changes.
US Airways has set important prece-dents in its two Chapter 11 filings that cannotbe ignored by competitors. However, theimplications are made much less significantby the fact that the company still faces highrisk of liquidation this winter (and it is small-er than the other legacy carriers).
The airline entered Chapter 11 in mid-September - for the second time in two years- as most of its unions rejected a plan to cutlabour costs by a further $950m, after $1bnof concessions agreed to in 2002. Only pilotsand some small unions had agreed to addi-tional concessions totaling $340m. Afterimposing temporary 21% pay cuts, in mid-November US Airways filed motions to ter-minate three union contracts (coveringground workers, mechanics and flight atten-dants) and its remaining defined-benefitpension plans. Hearings on those motionsbegan on December 2.
US Airways is in danger of not making itpast January or February because of weak
Aviation Strategy
Analysis
December 200410
cash reserves and covenant and otherissues with loans and financing agreements.In addition, its flight attendants and groundworkers have threatened to strike in theevent that the collective bargaining agree-ments are abrogated - any strike wouldeffectively be a death sentence. However, ifUS Airways gets all the targeted cost sav-ings and makes it through the winter, it couldemerge from Chapter 11 with a cost struc-ture similar to that of LCCs. It would have cutits labour costs by 60% from the 2000 level.
American is expected to go into a sec-ond round of concessions talks to stay com-petitive, in response to United's cuts andespecially now that Continental has joinedthe fray. The airline has come a long waysince April 2003, when it averted Chapter 11by securing $1.8bn of annual wage and ben-efit concessions. Now one of the financiallyhealthiest legacy carriers, American hasnoted on several occasions recently that the$4bn-plus annual cost savings achievedsince September 11 are not enough.Significantly, its pilots have also acknowl-edged that.
Northwest has so far secured only$300m of its overall goal of $950m annuallabour cost savings. The bulk of those camefrom a recent interim contract with pilots,which cuts pay by 15% annually over twoyears and leaves the pilots among the bestpaid in the industry. The annual saving is$265m, instead of the $440m asked for.Northwest is in a relatively strong financialposition, but it needs to reduce labour coststo remain competitive. It accepted an interimdeal, first, because it had financial covenantissues - it was subsequently able to renego-tiate a $975m credit agreement. Second,Northwest wanted the pilot deal as a "bridgestrategy", to help get concessions from othergroups, mainly mechanics and flight atten-dants. The airline has told its pilots that it willhave to ask for more concessions in thefuture.
Delta, which has been fighting to stayout of bankruptcy, recently secured a newpilot contract that will result in $1bn annual
cost savings through wage cuts and benefitand work rule changes. Many of the key pro-visions took effect on December 1. The dealwas part of efforts to achieve $5bn in annualfinancial benefits from a multitude ofsources, as compared to the 2002 level.Some recent successes on the debt restruc-turing front have done much to avert thethreat of Chapter 11 for the near term.However, the pilot cost cuts are probably notenough to give Delta a competitive pilot coststructure (it does not have a cost problemwith other work groups).
Even though some of the legacy carrierswill inevitably find it tough to get their labourcosts competitive, there is now a sense thatthe industry wage bar is falling faster thananticipated. One consequence noted by JPMorgan analyst Jamie Baker: "As wagerates fall, the economics of legacy airlinesand LCCs continue to converge". Baker sug-gested that valuations would converge aswell, meaning lower valuations for LCCs andhigher valuations for the "rapidly rejuvenat-ing" legacies.
The trend of the economics convergingmay be accentuated by changes in the ageprofiles of work forces. LCCs have lowerlabour costs for two main reasons: betterwork rules and younger workers on lowerpay scales. While the work rule gap is obvi-ously lessening, some of the cost differentialis eroding as LCCs' employees age and thelegacies reduce their work forces (particular-ly through early retirement and other volun-tary programmes).
The other area where costs will be con-verging is pensions. There is now a consen-sus among legacy airline managements thatthe traditional defined-benefit plans will haveto go. But there are no clear solutions onhow pension reform could be implementedwithout disadvantaging employees or affect-ing the competitive positions of airlines. Theindustry is waiting to hear how the bankrupt-cy court will rule on UAL's request to termi-nate its four pension plans. Also, Continentalmade the point that there should be con-gressional leadership on that issue in 2005.
Aviation Strategy
Analysis
December 200411
By Heini Nuutinen
ATA Airlines' decision to sell its ChicagoMidway hub operations - announced in
conjunction with its Chapter 11 filing onOctober 26 - has opened up a uniquelyattractive growth opportunity for one or moreof the financially stronger LCCs. WhileAirTran is the front runner, having alreadysigned a $90m asset acquisition agreementwith ATA, Southwest and America West mayalso submit bids for all or part of the bank-rupt carrier.
The deadline for the bids is December10, and ATA's bankruptcy judge is expectedto pick winner on December 16. However,there is potential for complications anddelays, because the decision will also haveto be approved by the City of Chicago - theparty that ultimately decides how the Midwaygates are reallocated.
If AirTran emerges as the winner - apotentially good scenario for all ATA stake-holders except possibly employees - thecompetitive implications are significant. Itwould set the stage for a mighty clash withSouthwest, which is Midway's largest opera-tor with a 42% passenger share (comparedto ATA's 39% share, plus 5% held by itscommuter unit Chicago Express Airlines)and is keen to expand significantly at thatairport. It would be the first major confronta-tion between a strong new-generation (post-1990) LCC and Southwest.
After ATA's bankruptcy filing, Southwestimmediately announced that its number onepriority is Chicago Midway. It has some roomto grow there within its existing 19 gates andhas already announced plans to add 24 newdaily flights in the first quarter, to boost itstotal Midway frequencies from 145 to 169.Essentially all of its 10 new 737-700s sched-uled for delivery in the first quarter will go toMidway.
If Southwest gets the 6-7 additional gatesit is believed to be seeking, it could over timebuild Midway into its largest hub. This wouldobviously have negative impact on United's
and American's important Chicago O'Harehub.
America West is known to be interestedin ATA's 14 Midway gates, as well as itsETOPS certification. It does not currentlyserve Midway (only O'Hare) and would like amid-continent hub. However, it may not beable to justify it to its shareholders. The sce-nario of America West successfully biddingfor all or a substantial part of ATA has metwith disapproval in the financial community.This is mainly because of the substantial riskinvolved in integrating the acquisition,including employees and a new fleet type - arisk that seems unacceptable in the currentindustry environment. Also, althoughAmerica West is used to competing withSouthwest in Phoenix and Las Vegas, itmight be a better idea to diversify away fromthat exposure.
JetBlue has also been mentioned as apotential bidder for some of ATA's gates.However, building Chicago operations is nota priority for the New York City-based carri-er, which has lots of exciting growth opportu-nities lined up elsewhere for its rapidly grow-ing A320 fleet. It is also busy planning for thestart of E190 operations in the latter part of2005.
Mesa's name was also mentioned earlierin the ATA context, partly because the largeregional is an old hand at M&A and partlybecause it is looking to diversify risk awayfrom US Airways, United and Delta feederoperations. The most likely way it would getinto Chicago would be as America West'sfeeder partner.
For its part, ATA has certainly played itscards right. It may or may not succeed inreorganising, but the bankruptcy process willat least give it a chance. Chapter 11 willenable it to implement a fleet and aircraftlease restructuring - ATA's 737-800s are toolarge for the Midway markets, and its leasesexceed market rates to the tune of $100mannually.
Aviation Strategy
Analysis
December 200412
Opportunitiesat Chicago Midway
With the AirTran deal, ATA secured abuyer and a good price for the assets that itfeels it can part with, while still keeping thedoor open for better offers. The BankruptcyCode generally provides for an auction toallow higher and better offers - from the pointof view of all stakeholders - when a compa-ny in Chapter 11 seeks to sell assets.AirTran will be the "stalking horse" bidder,but it will be able to collect a $3.75m termi-nation fee and up to $1bn of expenses ifanother offer is accepted.
Selling the Midway operation will enableATA to focus on its home base and main hubat Indianapolis. It also plans to continueoperating Hawaii service, military chartersand some commercial charters. The ATSBhas provided some flexibility in respect ofATA's $168m partially government-guaran-teed loan, while Indiana TransportationFinance Authority has provided a $15.5msecured DIP financing (via an aircraft-partsale-leaseback transaction).
The deal with AirTran, which the two par-ties hope to close by December 23, wouldmean the Orlando-based carrier taking overATA's gate leases and routes at Midway, aswell as slots at New York LaGuardia andWashington National. Initially, AirTran wouldwetlease up to 12 of ATA's 18 leased 737-800s for the routes, before introducing itsown 137-seat 737-700s from June 2005.ATA's 3,200 employees in Chicago wouldnot be guaranteed jobs with AirTran, butmany would obviously be taken on. The twoairlines would forge marketing and code-share pacts, including a link betweenChicago Express and AirTran.
The deal would provide an immediate liq-uidity boost. AirTran would pay $42m in cashto ATA at closing, plus $7m to the City ofChicago to retire airport facility debt, fol-lowed by $19m of further payments to ATAby April. The remaining $22m of the $90mpurchase price would be paid over an eight-year period, subject to AirTran being able tocontinue to use ATA's slot exemptions atLaGuardia and National (over which there issome uncertainty).
This is a very attractive opportunity forAirTran to diversify risk away from Atlanta,get a second hub, establish a significant
presence in one of the nation's largest travelmarkets, and find somewhere to put the 100737-700s it has on order or option. Currently,the airline operates just one gate at Midway,though it is able to add a second gate andsome new flights in January, independent ofthe ATA transaction. The ATA deal wouldenable AirTran to reduce Atlanta's share ofits total capacity from 70% at present to 55%by the end of 2005.
AirTran expects to operate the ATA routesprofitably, thanks to its smaller aircraft andbetter lease terms. It will minimise risk andstart-up hassles by entering the marketsgradually - and not having to integrate air-craft and employees in the longer term.Analysts do not expect the transaction tohave negative profit impact in 2005, and inthe longer term it should significantly boostAirTran's earnings. Since the deal wasannounced, AirTran's share price hassurged from around $10 to the $12-13range.
Credit rating agencies have not beenquite as negative about AirTran's proposedtransaction as they usually are about acqui-sitions. Notably, Moody's reportedlyacknowledged that it is not every day thatgates and capacity become available at oneof the country's most desirable airports, andthat the airlines need to take the opportunityas it arises. But AirTran's credit ratings nowhave negative outlooks, as the agenciesworry about AirTran's debt leverage,Southwest and other risks.
Among equity analysts, UBS' RobertAshcroft has probably taken the most nega-tive view. He downgraded his AirTran stockrating in late November, partly on valuationand partly because he felt that AirTran hasunderestimated the risk of contracting withATA in the interim and the pain thatSouthwest can cause. Ashcroft suggestedthat AirTran should give Southwest some ofthe gates and only build an 8-10 gateMidway operation, which would "provideAirTran with sufficient shelter from the stormin 2005 while exposing it to less risk".
AirTran executives have brushed off con-cerns about Southwest, saying that AirTranhas a similar low cost structure and hascompeted very successfully with Southwest
Aviation Strategy
Analysis
December 200413
in East Coast markets. A heavy exposure toDelta in Atlanta is also risky, and Chicagowould not become AirTran's primary hub.Also, as president Robert Fornaro pointedout in a recent conference call: "Southwestwill be everywhere eventually, so you haveto be able to compete with them".
Some analysts have made the point thatthe AirTran deal might be the best for theindustry, because it would remove capacityfrom the domestic market through the use ofsmaller aircraft.
While Southwest and America West arealso mainly interested in Midway gates, theycould also bid for some of ATA's 737-800s.Southwest's CEO Gary Kelly noted recentlythat the airline might have to add a different737 model, such as the 800-series, for anyadditional near-term growth, because thereare not many 737-700s available in the usedmarket. However, bidding for ATA's 737-800s will not improve an offer's chances,because the lessors should have no difficul-ty placing those aircraft with new customers.
But the situation is obviously differentregarding employees. The City of Chicagohas reportedly said that it wants any gatebidder to also take on ATA employees. Thisis one area where there could be significantdisagreement, with ATA and its creditorsbacking the AirTran bid but the City prefer-ring one from America West.
Regardless of who ultimately wins, theATA bankruptcy process offers some point-ers for things to come further down the air-line consolidation road, for example with US
Airways. First of all, it is becoming clear thatthe immediate beneficiaries from airline fail-ures will be the LCCs, rather than the legacycarriers.
Second, consolidation is likely to takeplace through asset buyouts, not mergers.Most airline mergers have been difficult andexpensive, with complicated fleet and labourissues, and have typically not created valuefor shareholders. Now there is also a lack ofinvestment funds, lack of management time(with focus still on liquidity and survivalissues) and lack of goodwill on the part ofemployees (after all the sacrifices made).
Third, Southwest is definitely becomingmore aggressive and is likely to play agreater role in the industry consolidationprocess. Whether this is because a moreassertive CEO is at the helm, because otherLCCs are gaining ground or because goodopportunities are presenting themselves(mainly the latter two), Southwest's ASMgrowth is likely to well exceed its customary10% annual rate in the next few years.Currently, its plans still envisage 10% growthin 2005, following 6.9% this year. Calling thisa "period of unbelievable change in the air-line industry", Kelly said recently that thecompany is keeping an eye on growthopportunities that may open if other airlinessell assets.
Aviation Strategy
Analysis
December 200414
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Air Berlin has grown steadily to become notjust the second-largest airline in Germany
in terms of passengers carried, but also thethird-largest LCC in the whole of Europe. Butcan the Tegel-based airline retain its indepen-dence against the onslaught of easyJet andRyanair into the lucrative German market?
Air Berlin was founded by Kim Lundgren in1978 as a charter airline based in the US, sinceonly aircraft owned by the Second World War'sAllied nations were allowed to land in Berlin.Once this rule ended, German investorsbought into the company in 1992, and today AirBerlin is owned by Reidun and Kim Lundgren(26%), Severin and Rudolf Schulte (25%),Hans-Joachim Knieps (25%), Werner Huehn(15%) and Joachim Hunold (9%), who is alsothe airline's managing partner.
Originally Air Berlin sold its capacity toGerman package tour operators, but seat-onlytickets began to be sold direct to the publiconce the airline had built up frequencies on keyroutes such as the so-called "Majorca Shuttle",which today links the popular Balearic islandwith 12 cities across Germany through morethan 200 flights a week in the summer season.Mallorca is also a major hub for Air Berlin, andthe island is linked with 12 destinations in theIberian peninsula as well as to Austria,Switzerland and the UK. In the rest of its char-ter network, Air Berlin connects 16 Germancities with holiday destinations across theMediterranean and north Africa.
However, in the early 2000s Air Berlinrealised that prospects for the charter marketwere not good - both in the short-term, giventhe recession in the German economy and inthe long-term given the structural drift awayfrom packaged holidays - and in October 2002the airline launched the first of its City Shuttleservices. The shuttles provide daily servicesbetween key cities and offer both businesspassengers and leisure travellers a low fareproduct. Today there are shuttles between ninemajor German cities and Barcelona, Budapest,London Stansted, Manchester, Madrid (starting
December 18), Milan Bergamo, Rome,Southampton, Warsaw, Vienna and Zurich. AirBerlin claims that its City Shuttle services havealready recouped their initial investment, andare profitable.
Altogether, as both a charter airline and alow fare carrier, Air Berlin operates to 57 desti-nations across Europe, and in 2003 carried9.6m passengers - a substantial 43% rise on2002. Of those, 4.8m were scheduled passen-gers (2.3m in 2002), making Air Berlin secondonly to Lufthansa in the German market in thenon-charter market (Lufthansa carried 45.4mpassengers in 2003), and ahead of DBA,which carried 3.1m passengers in 2003. Butthough scheduled passengers are now thefuture for Air Berlin, the charter sector is stillsubstantial, and in 2003 the number of pas-sengers carried to Mallorca rose by 53%, to2.9m.
Air Berlin expects to carry around 11.6mpassengers this year, and in January-September passengers carried rose 38.5%compared with the same period in 2003. InSeptember the airline's load factor reached87%, and for the first nine months of the yearload factor was 81%, two percentage points upon the same period in 2003.
The airline has 2,200 employees, half ofwhom originate from the former East Germanstate, but as Air Berlin is privately owned, itsfinancial position is difficult to assess. Althoughrevenue rose 26% in 2003 to €894m, it isbelieved to have made a small net loss thatyear thanks to the Gulf war and a downturn intour operator business. For 2004 the airline isexpecting revenue to top the €1bn mark(€1.07bn is the latest forecast), and in the firstthree-quarters of the year revenue rose by19% to €797m - though this is still dwarfed byLufthansa's annual turnover of €15.9bn. Full-year profit of up to €40m is forecast, though AirBerlin says 2004 profits would have topped the€100m level if it were not for the increase infuel prices - a statement that implies Air Berlinhas little hedging against fuel price rises.
Aviation Strategy
Briefing
December 200415
Air Berlin battles through Germany's LCC wars
The Lauda link
In January 2004 Air Berlin bought a 24%stake in Niki, the airline launched by Niki Laudain November 2003 out of the Austrian assets offailed German charter airline Aero Lloyd. At thestart of 2004 Niki operated just one A320 andone A321 on charter flights from Vienna andSalzburg to Mediterranean holiday destina-tions, but the link with Air Berlin enabled Laudato move the airline towards the LCC model.
Air Berlin and Niki agreed to co-operate ina number of areas, including shared sales andmarketing, CRS, co-ordination of schedulesand joint logistics. Following the partnership,Niki acquired two more A320s and in Maylaunched City Shuttle services from Vienna toRome, Warsaw and Zurich. A fourth city shut-tle came in November with the launch of a dailyVienna-London Stansted route, while a dailyVienna-Paris service will start in February2005. Niki's flights to Mallorca have also beenintegrated into Air Berlin's hub operation there.
Up until October 31st, Niki carried 970,000passengers and had revenue of €70m, pro-ducing a small net profit, it is believed. Both air-lines state that Air Berlin has no plans to raiseits stake in Niki in the future, and in any caseLauda would be reluctant to lose a controllingstake.
From Air Berlin's point of view, the partner-ship secures access to the Austrian marketand enables the airlines to co-ordinate thelaunch of new routes into eastern Europe,where growing demand from the new EUnations is still outstripping capacity beingadded by western airlines. Air Berlin operatesto Warsaw (from BerlinTegel) and Budapest
(from Berlin Tegel, Dusseldorf and Munich),both of which commenced in the summer afterPoland and Hungary joined the EU, while AirBerlin and Niki are examining services out ofVienna to Russia sometime in 2005.
The fleet
Air Berlin operates a fleet of 42 737s withan average age of less than three years,around half of which are leased. Air Berlin alsowet leases three Fokker 100s from Germaniaas part of deal to operate Germania Express(Germania's LCC) routes from Berlin Tegel,Hamburg, Munich and Dusseldorf to Viennaand Zurich.
In 2003 Air Berlin experimented with thewet lease of three BAe 146s on a City Shuttleroute out of Monchengladbach (also known asDusseldorf Express Airport), but switched theservice to 737s out of nearby Dusseldorf air-port after finding the aircraft "very expensive".
After months of speculation, in November2004 Air Berlin announced it had completedwhat was a "complex decision" and was order-ing up to 70 A320 family aircraft - 60 for its fleetand 10 for partner Niki - with options for anoth-er 40 aircraft. All the aircraft will contain 174seats in a single-class configuration. Niki cur-rently operates two A321s and three A320s,but these will all be replaced by the newarrivals, so its fleet will expand to 10 aircraft.For Air Berlin, the move away from Boeing toAirbus is a major change, and yet another blowfor Boeing, which had expected - at worst - thatthe order would be split between the two man-ufacturers. Inevitably, Boeing claims thatAirbus only won the order after dropping itsprice per aircraft to a very low level - though AirBerlin insists that other issues, such as deliveryslots, were an issue. A decision on engines hasyet to be made, and again there is a differencebetween the prior policies of the two airlines:Niki's Airbuses use International Aero EnginesV2500s, while Air Berlin's Boeing fleet usesCFM engines.
The firm order is believed to be wortharound €3.4bn, and aircraft will start arriving inthe third quarter of 2005, continuing until 2011.A consortium of banks is financing the order,and it is believed that Air Berlin will buy around
Aviation Strategy
Briefing
December 200416
0
250
500
750
1,000
1,250
1999 2000 2001 2002 2003 2004F
€m AIR BERLIN’SOPERATING REVENUES
half of the new aircraft and lease the other half.Final decisions on the models have yet to bemade, and Air Berlin has not yet made clearhow many of the 60 A320s will immediatelyreplace existing 737s (some of which areleased) and how many will be for fleet expan-sion - though it's likely that many of the aircraftwill be used for new routes and extra frequen-cies on existing services. Air Berlin has alreadyannounced it is expanding its workforce by hir-ing another 350 flight personnel in 2005.
Seven extra aircraft will be available by theend of summer 2005, bringing the fleet up to52, and this capacity will be used on routes toeastern Europe, and - in a direct challenge toeasyJet - on extra flights to London Stansted,Manchester and Southampton. This will comeon top of four new routes launched to the UKin November 2004 - daily flights on BerlinTegel-Manchester and Dusseldorf-Manchester, a three-times-a week service onPaderborn-Southampton and a four-times-a-week service on Paderborn-Manchester. TheDusseldorf-Manchester route competesagainst both Lufthansa and British AirwaysCitiExpress, while Berlin Tegel-Manchester isalso served by CitiExpress. These routesjoined Air Berlin's existing services to the UK -routes from six German cities and Mallorca, allto London Stansted, and which between themgenerated almost three quarters of a millionpassengers in 2003.
Air Berlin is also expanding its Spanishoperations. In September Air Berlin announcedit would build up Madrid airport into a hub oper-ation, connecting the airport to 24 destinationsin Germany, Switzerland and Austria, with allroutes going via Mallorca. And in the samemonth Air Berlin launched a Bilbao-Mallorcaroute, allowing passengers from Bilbao to con-nect with 18 destinations in Germany, Austriaand Switzerland.
Air Berlin is launching a daily Berlin-Madridshuttle on December 18, though in Septemberit complained about the inefficiency of Spanishairports, which was forcing it to increase faresby up to 8% on routes to the country, as well asthe need to improve the facilities at Palma air-port on Mallorca, home of its hub operation.
Air Berlin is looking to build hubs elsewherein Europe. Basel is one destination under con-sideration, and the airline is believed to be talk-
ing to the airport authorities there.However, this appears a prettyunlikely candidate for major opera-tions, given its proximity to Niki'soperations in Zurich - unless Baselairport can come up with lower air-port charges.
A real LCC?
With lots of capacity being added and withtour operator business looking less than robustin the long-term (as the trend towards self-assembly holidays continues), Air Berlin willexpand its City Shuttle network of low fareroutes aggressively. Although its City Shuttlesare a recent concept, in many ways Air Berlinhas been ahead of its time. Before the LCCmodel came to Europe, Air Berlin was offeringflights from secondary German airports suchas Dresden, Munster/Osnabruck, Paderbornand Nuremberg, although now its strategy ismuch more about major city-to-city routes pop-ular with business travellers than flyingbetween secondary airports. Another differ-ence with the traditional LCC business modelis that Air Berlin has a strategy of signing sim-ple partnerships (it dislikes what it calls com-plex interline deals) with other airlines. Thesedeals feature one partner completely takingover services from the other on selectedroutes, and vice versa.
But is Air Berlin a true low cost airline?Given the lack of publicly available information,it's difficult to verify, but Air Berlin probably doeshave the lowest cost base of any airline inGermany, thanks to (at the moment) a young,all 737-fleet and relatively low labour costs. Butas much as Air Berlin says it is now targetingLufthansa on city-to-city routes, it's not thecosts of the German flag carrier that Air Berlinhas to beat, but those of easyJet and Ryanair.Certainly in terms of productivity, Air Berlin lagsbehind easyJet - Air Berlin's passengers car-ried per employee will be around 5,300 in2004, compared with approximately 10,000 foreasyJet (and 1,300 at Lufthansa, albeit on aglobal network).
The question of how low Air Berlin's costsare is crucial, since LCCs are starting to flooda market where fares have traditionally been
Aviation Strategy
Briefing
December 200417
FleetOrders
(options)737-400 5737-700 3737-800 34 (2)A320 family 60 (40*)F100 3Total 45 60 (42)Note: *Options shared with Niki
AIR BERLIN’S FLEET
high. Rivals include not only German competi-tors such as Hapag-Lloyd Express andGerman Wings, but also foreign LCCs, crucial-ly easyJet and Ryanair.
Michael O'Leary, CEO of Ryanair, says thatthere will be a "mother and father of all wars" inthe German aviation industry, while RayWebster, CEO of easyJet, has stated "it is notpossible for small companies to survive inGermany". easyJet entered the German mar-ket in a big way in 2004 (after not taking up itsoption to buy DBA) by opening a hub at BerlinSchonefeld (also known as BrandenburgInternational) in April - a direct challenge to AirBerlin, Germania and Condor, all of whichoperate out of the airport (as well as out ofTegel). Six easyJet aircraft are stationed atSchonefeld, operating to 20 destinationsthroughout Europe. The latest tranche ofroutes were launched on November 25, withservices between Berlin and Bratislava,Geneva, Ljubljana, and Riga. After Berlin,easyJet started operating out of Dortmund inJuly (and now operates to 9 destinations fromthere) and it also has four routes from Munichand Cologne/Bonn to the UK.
Ryanair started flying to Germany way backin 1999, and in July 2004 passed a total of 10mpassengers carried to-from Germany. It has amajor base at Frankfurt Hahn airport, (with fiveaircraft operating to 22 destinations), plussmaller operations at Dusseldorf Weeze air-port (five destinations), Hamburg/Lubeck (fivedestinations). It also flies into Karlsruhe/Baden,Friedrichshafen, Berlin Schonefeld,Altenburg/Leipzig and Erfurt (though itsLondon Stansted-Erfurt route is closing inJanuary as part of a "weeding out of under-per-
forming routes"). It is almost inevitable that there will be casu-
alties in the German LCC sector. According tosome analysts, there is overcapacity of morethan 20% in the German low-fare market, andthat's before easyJet's full entry - it aloneexpects to carry 1.5m passengers to and fromGermany in the first 12 months of business.easyJet says that its average fare (across allroutes) is €58, whereas it claims Air Berlin'saverage fare is €93, DBA's is €111 andLufthansa's is €268.
However, the growth of foreign LCCs in theGerman market is starting to unite domesticairlines that otherwise would be loathe to co-operate with each other. Initially, Air Berlin wason its own in resisting easyJet. In February2004 Air Berlin said it might pull out ofDortmund airport (its second most importantGerman base) in favour of Paderborn orMunster/Osnabruck, after easyJet stated itwould establish a hub there as well as BerlinSchonefeld. But once easyJet started opera-tions in Dortmund, Air Berlin was quicklybacked up by Lufthansa, and the two rivalscomplained about what they saw as the morefavourable charges levied by the airport oneasyJet. Air Berlin and Lufthansa - and thenHapag-Lloyd - unilaterally declared they wouldnot pay Dortmund airport the same fee perpassenger they had previously been paying -whether the airport agreed or not - and wouldinstead only pay landing fees in line with thecharges being levied on easyJet.
In Air Berlin's case, in September itdeclared it would pay €2 per passengerinstead of the €15 per passenger it had beencharged previously. Between them, Air Berlinand Lufthansa account for two-thirds ofDortmund's 0.9m passenger movements peryear, and the unilateral fees reduction is fore-cast to cost Dortmund airport around €12m peryear. Whether Dortmund airport will fight theseunilateral reductions, accept them or (as theGerman airlines may prefer) raise easyJet'sfees, remains to be seen.
The battle against easyJet has spread toother German airports. Hapag-Lloyd - TUI'scharter airline - threatened to leave its base atHannover airport if the authorities allowedeasyJet to also establish a hub there. Air Berlinand Germania Express backed up this threat.
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02
468
10
1214
1999 2000 2001 2002 2003 2004F
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AIR BERLIN-PASSENGERS CARRIED
TUI employs 1,100 staff at Hannover, and theairport announced that its overriding concernwas to protect those positions. Shortly after-wards, in July, easyJet dropped its plans forHannover operations.
The increasing threat from easyJet is a keyfactor between a growing relationship betweenAir Berlin and Hapag-Lloyd. Since July AirBerlin has been codesharing with Hapag-Lloydon selected charter routes, and fromNovember 2004 that was extended to the sum-mer of 2005, with codesharing on approxi-mately 300 flights on popular holiday routesout of Munich, Nurnberg and Stuttgart, with AirBerlin focusing on routes to Mallorca and main-land Spain, and Hapag-Lloyd focusing on ser-vices to the Canary Islands. The airlines arealso selling each other's flights.
There was speculation over the summerthat this might lead to a full merger, or at thevery least that TUI would acquire a stake in AirBerlin. In the past Air Berlin has held talksabout strategic partnerships with the giant touroperator, but that appears unlikely in the short-and medium term given that Air Berlin has thefinances it needs for its large fleet order and itcan get substantial benefits from codesharingwith Hapag-Lloyd, without the need for equityties. However, a growing relationship betweenAir Berlin and Hapag-Lloyd could spell the endfor TUI's LCC, Hapag-Lloyd Express (HLX).Hapag-Lloyd Express was launched inDecember 2002 at a cost of €100m, but itsongoing cost base may well be higher than AirBerlin's.
Elsewhere, the battle against easyJet con-tinues. In October 2004, after a complaint byAir Berlin, a German court ordered BerlinSchonefeld Airport to change the prices itcharges to LCCs. Air Berlin argued thatSchonefeld charged easyJet less than AirBerlin was being charged (by the same airportoperator) at Berlin Tegel airport, and again,Lufthansa backed up Air Berlin's complaint. AirBerlin has hinted it might have to think hardabout whether to switch all its Berlin services toTegel, but this is not believed to be a seriousoption
In October 2004 Air Berlin also entered intotalks over an expanded sales and marketingagreement with LCC Germania, building onthe existing wet lease agreement between the
two airlines.
Up for an IPO?
In early 2004 Air Berlin said it was consid-ering a stock market listing in the next 18months, in order to raise the capital needed forits impending fleet order, and reports out ofGermany say it began preliminary discussionswith UBS.
At the time the airline stated that its currentowners could not afford to invest further intothe company, so that was why an IPO wasbeing examined. In September however, theairline announced it would not be seeking alisting in the short- and medium-term, as it hadcome to an agreement with a consortium ofbanks for financing of its impending fleet order.The owners, which include managing directorJoachim Hunold, may be keen to keep the air-line away from the scrutiny of analysts andfinancial reporting requirements, thoughGerman analysts believe there may be a splitamong the shareholders, with Hunold believedto be less cautious about a flotation that someof the others, such as the Schulte brothers.
A complicating factor is that Air Berlin isaggressively anti-union, and is reluctant toallow its workers to have representation.Through 2004, Vereinigung Cockpit, theGerman pilots' union, has been trying tounionise workers, though Air Berlin is deliber-ately organised into small business units, eachof which are too small to come under the effectof Germany's union laws.
However, German law requires companiesundergoing a flotation with more than 2,000employees to allow workers' representatives tohave half the seats on the supervisory board. Away round this would be to float in anothercountry, though that would strain relationsbetween management and workers even fur-ther. But with Hunold reportedly saying that "I'ddestroy everything I built up if workers enteredthe boardroom", it's difficult to see how the rela-tionship could get any worse.
If Air Berlin doesn't go for an IPO, then analternative for long-term funding would be apartial trade sale. Given the right strategicinvestor, this would also secure Air Berlin'sfuture, and so seems its most likely option.
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Aviation Strategy
Databases
December 200420
Group Group Group Group Operating Net Total Total Load Total Grouprevenue costs op. profit net profit margin margin ASK RPK factor pax. employees
*Note: US Airways’ financial results are for the 9 months up to Dec 31, 2003. Operating statistics are for the full year.
Note: Annual figures may not add up to sum of interim results due to adjustments and consolidation. 1 ASM = 1.6093 ASK. All US airline Financial Year Ends are 31/12.
Aviation Strategy
Databases
December 200421
Group Group Group Group Operating Net Total Total Load Total Grouprevenue costs op. profit net profit margin margin ASK RPK factor pax. employees
US$m US$m US$m US$m m m 000sAir FranceYE 31/03 Year 2002/03 13,702 13,495 207 130 1.5% 0.9% 131,247 99,960 76.2% 71,525
Note: Annual figures may not add up to sum of interim results due to adjustments and consolidation. * = Preliminary consolidated figures for Air France Group from April-June, KLM Group from May-June
Aviation Strategy
Databases
22December 2004
Group Group Group Group Operating Net Total Total Load Total Grouprevenue costs op. profit net profit margin margin ASK RPK factor pax. employees
US$m US$m US$m US$m m m 000sANAYE 31/03 Year 2001/02 9,714 9,529 185 -76 1.9% -0.8% 87,908 57,904 64.7% 49,306
Note: US Majors = Aloha, Alaska, American, Am. West, American Transair, Continental, Cont. Micronesia, Delta, HawaiianJetBlue, MidWest Express, Northwest,Southwest, United and US Airways Source: ATA
US MAJORS’ SCHEDULED TRAFFIC
Intra-Europe North Atlantic Europe-Far East Total long-haul Total Int'lASK RPK LF ASK RPK LF ASK RPK LF ASK RPK LF ASK RPK LF
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