3 Key Takeaways from Deutsche Lufthansa AG Q3 Earnings

Figures in this article reflect prices as of market close on 11.07.2014 unless otherwise indicated.

Lufthansa (ETR: LHA) reported its third quarter earnings at the end of October and its share price dropped 5% in response. The stock has recovered since, but it is still trading 7 % lower than it did in early September when I wrote my previous article arguing against investing in the company.

What has happened in the meantime and why did the market react so negatively to the quarterly report? Here are the top takeaways from the prior quarter.

1.  Better than expected Q3 results

First, the good news: The company delivered better-than-expected results in the last quarter. Compared to the year before, sales increased 1.9% to €8.5 billion and operating results rose 25% to €735 million, beating analyst consensus of €662 million.

For the first nine months of 2014, sales have basically stayed flat at €22.6 billion while operating profits have increased from €663 million to €849 million. This looks like a strong increase, but it was driven by an accounting adjustment: Lufthansa changed the depreciation method for its fleet in 2014 — increasing the useful life of its aircraft from 15 to 20 years — and this had a €267 million positive impact between January and September. Once we adjust for this, operating profits were actually down by €74 million (or 11%).

According to management, the various strikes have resulted in lost profits of €105 million for the first nine months, so we can deduce that the underlying operations would have resulted in an increase of about €30 million (or 5%) in operating profits otherwise. The key driver for this is a reduction in restructuring and other one-off project costs compared to 2013, as well as lower fuel costs.

As a result, the company has re-iterated its guidance for 2014 for around €1 billion in operating profits (excluding further strike costs).

2.  Challenging industry environment

Now, the bad news: The environment in the airline industry — and Lufthansa’s position within the industry — continues to be challenging.

Even though worldwide volumes (measured in Revenue Passenger-Kilometers or RPK) have increased by 5.8% in the first eight months of 2014, Lufthansa could only grow its RPK by 2.6%. The strongest growth worldwide (over 12%) came from the Middle East carriers.

Moreover, Lufthansa’s volume increase was accompanied by capacity increase (+2.2% Available Seat-Kilometers or ASK), which meant that the passenger load factor has only marginally improved from 80.3% to 80.6%.

There is also pressure on prices and average yield was down 3.6%. As one example of the impact of that pressure, Lufthansa decided to quit the Frankfurt-to-Abu Dhabi route as it became increasingly unprofitable amid the aggressive competition from the Middle Eastern carriers.

In order to improve its profit levels, the company keeps working on cost reduction. Its long-term “business optimisation” program “SCORE” (an acronym for “Synergies, Costs, Organisation, Revenue, Execution”)   is expected to generate over €1 billion in efficiency savings in both 2014 and 2015, and Lufthansa plans to outsource its IT Infrastructure operations to IBM, saving €70 million costs each year. At the same time, two of its biggest cost items — fuel and labor costs — are more complicated problems.

Even though fuel costs have dropped significantly over the last few months, Lufthansa recognizes only a small reduction of its costs as 79% of its 2014 fuel expenses — and 65% of its 2015 costs — are hedged at a comparatively high price.

On the labor side, the company has been in a protracted struggle with the different unions — chief among them the Lufthansa pilots’ union, Vereinigung Cockpit — to change the pilots’ early retirement system and to shift more business to the low-cost-carriers Germanwings and Eurowings where pilots are paid less. Travelers have had to live through seven strikes so far in 2014 (the worst one lasted for three days in April) and there is no end in sight. The company estimates the strikes have cost it €170 million through the end of October.

Not that Lufthansa is alone with these problems: Air France/KLM (FRA: AFR) has also tried to push more flights to Transavia, its own budget unit, but it abandoned its plans after a two-week strike in September which cost it more than €400 million.

However, the tide may be turning. According to a recent poll, more than half of the German population is against the striking pilots. The longer Lufthansa is able to withstand the short-term pressures of the strike, the bigger the chances are that the company will be able to negotiate a deal with substantial long-term benefits.

3.  Reduced outlook for 2015 and dividend warning

Lastly, a double feature for the ugly news: The company has also reduced its outlook for 2015 operating profits from €2 billion to “significantly above previous year” — which I suppose could mean anything between €1 billion and €2 billion. The key reasons for this are the above-mentioned challenges in the industry, and especially the strong price pressures and the rising labor costs, coupled with signs of further economic slowdown.

Furthermore, Lufthansa also warned that its 2014 dividend may be cut as a result of interest rate changes and restructuring costs related to the sale of its IT Infrastructure unit to IBM.

This would not be the first time that Lufthansa cut its dividend. In fact, over the last 10 years, there were two years with no dividend paid. In the other eight years, however, the dividend yield was always above 2.7%, and in two of these years it was above 6%. A dividend warning in a year where the originally-forecasted dividend yield was only slightly above 3% and the share price is significantly down, suggests to me that the company is having some cash flow problems. Looking at the cash flow statement confirms this: Compared to prior year, operating cash flow is down by almost €1 billion and free cash flow is only €229 million. That compares to over €1.5 billion a year ago.

Summary

Lufthansa’s troubles are not over. Even though the company is making some progress in reducing its costs, the market environment continues to be very challenging and there are no major catalysts in sight that would significantly shift its position within the industry. As a result, my initial assessment still stands and I would not recommend Lufthansa for a “buy and hold” investor.