3 Reasons to Buy Deutsche Lufthansa AG Shares

Richard Branson once said, “If you want to be a millionaire, start with a billion dollars and launch a new airline.”

Sir Richard should know: he founded Virgin Atlantic. Warren Buffett is also not a fan of the airline industry, calling it a “deathtrap for investors.”

Still, US airline stocks have been some of the best performers for investors in 2014, thanks to industry-wide capacity discipline, careful cost management, and the recent oil price slump. The AMEX Airline Index rose nearly 50% for the year and some airline stocks even doubled.

Is there any reason to believe that Deutsche Lufthansa AG (ETR:LHA) (FRA:LHA), Europe’s largest airline, can follow suit and reward its investors in 2015? While in overall I still have my doubts about the long-term investing thesis into airlines, here are three arguments to be optimistic about Lufthansa.

Declining oil prices

As the chart below shows, oil prices have dropped sharply in the last six months. The Brent Crude Oil spot price is down 49% compared to a year ago. As fuel expenses are a very important cost element for airlines — for Lufthansa, it is about 22% of its total operating expenses — a drop like this in fuel costs will have a significant positive impact in overall profits.

Brent Crude Oil spot price, USD/barrel

Source: Google Finance, 3 Feb 2015

According to Lufthansa’s official estimates, the company spent €6.7 billion on fuel in 2014, while it forecasts to spend only €5.8 billion in 2015 — a €900 million cost reduction. The reasons the drop is not bigger are twofold:

• 73% of fuel cost for 2015 are hedged at a $105 USD/barrel level, so the price drop will influence only a relatively small portion of the overall fuel need.
• Fuel costs are priced in US Dollars and a portion of the price drop is offset by a weakening euro, as Lufthansa will have to pay more euros for the US dollar prices.

At the same time, Lufthansa’s official estimates are based on oil forward prices of 55 Euro/barrel. The current 44 Euro/barrel price (as of 3.2.2014) would generate around 800 million euro additional savings for the company. This would bring the total savings on fuel to around 1.7 billion euros. Even if some of these savings would end up in lower customer prices, the impact on net profit should be very significant.

Progress with labor negotiations and other cost reductions

2014 was the year of strikes for Lufthansa as the company has been involved 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. Altogether there were 10 strikes last year, costing more than 200 million euros for Lufthansa.

However, there has also been progress. The company managed to close negotiations with flight crews of Austrian Airlines, one of the two Swiss pilots’ unions and, most recently, the pilots of Eurowings. And while there is still no end in sight for an agreement with the Lufthansa pilots, the tide may be turning: as Germans are increasingly against the striking pilots, the chances that Lufthansa will be able to negotiate a deal with substantial long-term benefits are getting better.

In addition to the labor negotiations, the company is also focusing on reducing other cost elements. Its long-term business optimization program “SCORE” is generating more and more efficiency savings — it is expected to generate over 1 billion EUR in both 2014 and 2015 — while the related restructuring and project costs are getting lower. As a result, non-fuel unit costs (“cost per available seat kilometer” or “CASK”) are expected to have dropped by 2% in 2014 after excluding one-offs and accounting changes.

Stable profit stream outside of airlines

Lufthansa has a strong presence outside the pure airline business: Its service companies — maintenance, repair and overhaul (MRO), catering, cargo and IT services — generate 24% of total revenues; MRO and catering are global leaders. These businesses grow faster than the Passenger Airline segment and have a healthier profit margin. Excluding the more volatile cargo business, they generate a steady profit of around half a billion euros even during an industry downturn.

It’s no surprise that the segment is one of the focus areas for future growth. By 2020 Lufthansa wants to generate 30% of its revenues from aviation services. In order to get there, the company is looking to expand geographically in Asia, the Middle East and North America and is assessing opportunities in adjacent markets, for example train catering.

Conclusion

While most airlines have historically been a disappointment for investors, the industry has had a renaissance lately. Lufthansa is in a better position than most European airlines to follow North America’s lead. It has a strong non-airline profit stream and is making progress in cost reduction, and it will be further be helped in the short run by falling fuel prices.

Having said that, there are still many things that can go wrong for the company and the industry in general. The arguments against buying Lufthansa shares will be covered in another article, though, so stay tuned to Fool.de.