Shares of Lufthansa (ETR: LHA) have dropped about 30% over the last three months. Could it be time to invest in Europe’s largest airline?
In short: I don’t think so. To understand why, let’s first look at the investment prospects of the airline industry in general, and then review Lufthansa’s position.
The airline industry — a “deathtrap for investors”
Airline investors have had disappointing results over the last century (fun fact: commercial aviation celebrates its 100-year old anniversary in 2014). Net profits of the industry averaged 0.1% of revenues between 1970-2010. An analysis from McKinsey & Co. shows that, over the last 20 years, the return on invested capital in airlines was below their Weighted Average Cost of Capital — or simply put, the actual returns vs. expected minimum returns — in each year. Warren Buffett is famously negative about airline investing. Here are some of his best quotes:
- “[The airline industry] has been a death trap for investors.”
- “You have got huge fixed costs, you have got strong labor unions and you have got commodity pricing. That’s not a great recipe for success.”
- “A capitalist (…) should have shot Orville Wright.”
Even the International Air Transport Association (IATA), the industry’s biggest trade association, confessed, that “air transport continues to create tremendous value for its users, passengers and shippers, and others in the value chain but destroys value for its airline equity investors” (emphasis mine).
Why is this the case? According to Harvard Business School Professor Michael Porter — one of the most cited authors in business and economics — there are few industries where his “Five Forces” are as strong as in the airline industry:
- The bargaining power of suppliers is high: There are labor unions and airline strikes, the Boeing/Airbus duopoly in aircraft manufacturing, and local monopolies at airports.
- The bargaining power of buyers is high: End customers are price sensitive, they can easily switch to another airline, and distribution channels are highly concentrated.
- The threat of substitute services is rising: For instance, web-conferencing, high-speed rail, and simply not travelling are growing options for air travelers.
- The threat of new entrants is high: Limited economies of scale, easy access to distribution systems, and low customer switching costs create low barriers to entry. More than 1,300 new airlines were established between 1970 and 2010.
- Rivalry among existing competitors is high: The product is perishable and (within the same class) very similar, sunk costs for the aircraft and flight are high but marginal costs per passenger are low (resulting in strong price discounting), and there are high exit barriers.
The following characteristics make investing in airlines even more hazardous:
- Government policies: For instance restrictions on cross-border investments, subsidies and bankruptcy procedures, and support for labor unions can make it very difficult to adopt a more effective industry structure.
- 25-30% of total costs are tied up in one input cost: That key cost is fuel and it’s mostly outside the airlines’ control.
- Outside events: Things like terrorist attacks, volcano eruptions, and epidemics can create serious, unpredictable disruptions to air travel, causing significant financial losses.
Is anybody generating investor value?
Overall, it is a pretty bleak view for wannabe airline investors. But is it still possible to find airlines that have consistently generated value for investors?
In the 2000s, only 14 major airlines managed to produce an average EBIT margin (Earnings Before Interest and Taxes, as a percentage of revenues) above 8% — which McKinsey & Co. believes is a good approximation for the minimum profit requirements by equity investors. The best performer was Ryanair (ETR: RY4B), with an average EBIT margin of over 20%.
In general, low-cost carriers — or LCCs, like Ryanair or the U.S.’s Southwest Airlines (ETR: SWN) — tend to do better than network airlines such as Lufthansa or Delta Airlines (ETR: OYC). There are a number of reasons for this, including: point-to-point flights create less pricing pressure than hub connections, suppliers have less bargaining power since LCCs often use secondary airports, there’s a limited number of aircraft types that they use, and they use a non-unionized workforce. Also, exit barriers are lower, so many LCCs end up exiting the industry, thereby allowing the remaining airlines to achieve higher profits.
Lufthansa is not one of the 14 airlines with an EBIT margin above 8%. Its average EBIT margin was 4.1% between 2001 and 2010, which is significantly better than the industry average of 0.7%, but well below the hoped-for minimum of 8%. The below graph shows revenue and profit development between 2009 and 2013. According to the latest forecast, 2014 normalized results will come in below 2013.
Lufthansa: The good news…
Even though Lufthansa is not one of the top airlines when it comes to constantly creating investor value, there are several positive aspects of its strategy that could lead to improved profitability. The top items are:
- Focus on adjacent segments of the air transport industry: Maintenance, repair and overhaul (MRO), catering, and IT services represent 16% of external revenues and are growing faster than the Passenger Airline and Logistics segments. These segments are more profitable than the airline business itself, and create a regular profit source even during downturn in the airline industry. Lufthansa is global leader in both the MRO and catering business.
- Increased efforts to shift business into Germanwings and Eurowings: These represent Lufthansa’s LCC arms within and outside Germany, including the planned introduction of long-haul operations. The LCC model can significantly reduce operating costs for the Group and is essential to counter competition.
- The European airline industry is much more fragmented than in North America: The top five companies have 40% of market share in Europe vs. 90% in North America. This provides more opportunities for further consolidation.
… and the bad news
Unfortunately, there are also multiple areas of concern for Lufthansa in addition to the concerns around the airline industry in general. The major ones are:
- Lufthansa has very high labor costs: German airline pilots earn twice as much as their American counterparts, and strong unions oppose any meaningful efforts to eliminate this competitive disadvantage. The strike in August was already the third in 2014, and it was against both the proposed changes to the pilots’ early retirement system, and the planned shift to more LCC flights (where pilots are paid less).
- Competition is strong and increasing: On the LCC side, even though Germanwings has a 20% cost advantage compared to traditional Lufthansa, some of the other European LCC providers have an additional 30% lower cost structure. On the network airlines side, the three Gulf carriers Emirates, Etihad and Qatar Airways — helped by generous subsidies from their respective governments — are pushing aggressively to capture a bigger share of the long-haul business between Europe and Asia.
- Lufthansa is buying lots of ultra-large aircraft: There is growing concern that after a few years of discipline, capacity is growing too fast, and that this growth is coming through the increased size of aircraft. Lufthansa bought more ultra-large aircraft than its European network competitors. Theoretically, this leads to a reduction in unit costs. However, there is a big concern that this will generate further price pressure in order to fill the planes.
My Foolish assessment
Airlines have consistently been a risky business, and more often than not they disappoint as an investment. There have only been a few airlines that have consistently rewarded their investors, and Lufthansa hasn’t been one of them. More importantly, unless some major catalysts take place — for instance, a meaningful breakthrough in labor relations or further consolidation in Europe/Asia with significant capacity and cost reduction opportunities — I don’t expect that this would change. At this point, none of these catalysts are in sight. As a result, I believe Foolish investors with a long-term “buy and hold” mindset are better off looking for other opportunities at the moment.
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