Delta’s Interest in CSeries Show Viability In Spite of Scope Clauses

Delta Air Lines nearing an order for the Bombardier CSeries is an important breakthrough for the program, which from its conception has always relied on its ability to score sales with US majors. The program was always designed to offer a tailored alternative to the Airbus A319 and Boeing 737-700 just above the scope clauses. But the CSeries’ delays saw the sweet spot in the single aisle market move upwards.

The CSeries was in serious jeopardy as airlines tried to move the scope clauses upwards to 100 seats – but they have faced more trouble than anticipated and have thus far been unsuccesful in enforcing this change. An order from Delta would now be a revitalizer for the program as airlines are forced to act due to ageing fleets.

Scope Clauses

While scope clauses are not necessarily unique to the American airline industry, it’s there that they are most common and of the greatest importance for aircraft sales. The clauses have always had a large impact on sales and even design of aircraft, challenging airframers to offer the ideal aircraft to maximize scope in regionals.

However, there is also the opposite effect: being just slightly over the scope clause could break a program’s neck. The CSeries’ delays have meant that with changing scope clauses, a once perfectly designed aircraft was now in the danger zone of being eliminated by airlines solely on the grounds of the scope clause.

A scope clause, generally spoken, is a limit imposed by a pilots union on the size of aircraft (in terms of seats and gross weight) that the unionized pilots can fly. The general limit is 76 seats and 86,000 pounds – a limit imposed by the unions to protect their jobs by preventing cheaper labor from regional airlines from taking over mainline flying.

This limit of 76 seats has caused the US regional airline industry to become uncompetitive as they were unable to exploit the very efficient stretched regional jets on offer by Embraer (E190/195) and others. Only a handful of them have been in operation in the US, and mostly with airlines that are not subject to scope clauses such as JetBlue.

Recent developments have seen a push by US majors to change the scope clause to 100 seats in order to be able to better use those larger regional jets –so far to no avail.

Effect on the CSeries

The effect scope clauses had on the CSeries so far was devastating: Not only did the aircraft not seem attractive to legacy mainlines, but the one US order it had from Republic Airways Holdings was more than in jeopardy because it was not feasible to fly it with few enough seats to allow a regional carrier to operate it.

Apart from all economical hurdles the CSeries faces with low oil prices and high unit costs, the scope clause has been what has most hurt its sales in the US. But as it becomes more and more unlikely that scope clauses will be adjusted to 100 seats and higher weight any time soon, the CSeries and similarly sized aircraft have seen a sudden surge of interest from US legacy carriers.

So far, Boeing and Airbus have won most of the recent orders in this field – by offering rock bottom prices (as much as 75% discount on the list prices) on their 737-700 and A319 aircraft. Bombardier has not been able or willing to match those prices in order to garner sales. However, with the Canadian government providing emergency aid to the ailing program, this does seem to have changed of late. It is unlikely that Delta, the industries master cost controller, would consider buying it otherwise.

CSeries + stretch = formidable

However the US mainlines also have a profound self interest in the success of the CSeries, as a third producer of single aisle aircraft has the potential of lowering prices all around – Boeing’s and Airbus’ success in recent RFPs that had seemed tailored to the CSeries show it is working for the airlines.

In fact, Delta’s recent ordering behavior seems to underscore the fact that this might be one of the main reasons for the carriers interest. Mid-sized narrowbodies have been suspiciously absent in the carriers’ order books of late, despite triple digits of ageing MD-80 Series aircraft coming up for replacement soon. Instead, Delta has only ordered the largest variants of the traditional narrowbody families, in part as scaleups, but also to replace old Boeing 757s.

While the CS100 and CS300 are attractive options on the lower end of the mainline narrowbody spectrum in themselves, Delta’s interest right now could be seen as the strongest indication yet that Bombardier might have been pushed into seriously studying stretching the CSeries into a 500 variant to effectively compete with the Airbus A320neo and Boeing 737-8, the respective airframers’ most recent models. Such a hypothetical CS500 version has been cited as highly competitive by several credible sources

This hypothesis is also strengthened by Delta’s reported order encompassing a rather large number of options, which is highly unusual for the carrier. The excercising of those options could be conditional on Bombardier launching a CS500. A large order from Delta could provide Bombardier with both the critical mass and cash influx to start such a program in the not too distant future; as well as provide the airframer with additional leverage in negotiations with Canada’s public hand for a bailout.

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Why LCCs Can’t Save Big on Long Haul

One of the main factors in the success of low cost carriers has been high asset utilization. They keep their turn times short and thus manage to squeeze in additional sectors into the schedules every day. On long haul aircraft, utilization is already sky high even for legacy carriers – as longer flights generate fewer turns. Additionally, long haul turn times are harder to reduce as they are dictated by more operational needs than short haul turns. They are also affected by an important factor that is virtually irrelevant on short haul: differing time zones. Especially on airports with a curfew, this can lead to significant scheduling inefficiencies that an LCC is just as unlikely to avoid as a legacy.
This problem could in some way be dealt with (thus increasing utilization) by departing and arriving at unpopular times in the middle of the night. However, it is unknown if passengers would accept this, as it creates new problems such as difficulty to get from or to the airport as public transportation is shut down for the night.

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LCCs rely on productivity and cost control

Productivity is a general problem for any airline. With a large share of largely unmanageable input prices such as fuel, controlling those costs that can be controlled becomes paramount, as does maximizing productivity.
Historically, LCCs have maximized their productivity by achieving seat factors in the mid to high eighties, something that legacies have not been able to copy. However, high seat factors of 80% or more have been a part of long haul flying for a long time now, limiting the potential for LCCs. Quite on the contrary even, productivity for LCCs could be much lower on long haul than it is for legacies, as LCCs lack networks to efficiently market cargo capacities.

Another way how LCCs have achieved superior productivity on short haul routes was maxing out the seating potential of their aircraft, something that legacies have since been copying. This copying has not ended on the short haul end of the business however, and increased seating density is now a staple in many airlines, leading to the dreaded 10-abreast seating in the 777 becoming the industry standard now.

A look on the cost side of long haul flying reveals that the share of unmanageable costs rises with the sector length. This is especially true for fuel, which can reach 50% of the overall costs of a long haul trip. AirAsiaX, one of the few successful long haul low cost carriers for example has an even share of 1.9USD cents per ASK for fuel and just as much for all other costs. This also means that as fuel prices rise, the cost advantage for LCCs becomes smaller.
One way AirAsiaX manages to save costs is staff roll. The share of crew costs is higher on long haul than on short haul, which is caused by indispensable overnights for crew but also generally higher experience and greater scarcity of qualified crews and the resulting need for more training. AirAsiaX and other LCCs have managed to save by reducing the number of crew members to the absolute safety minimum, relinquishing additional flight attendants that legacies take to offer better service on board. Other airlines such as Norwegian have adopted questionable work schemes that exploit a range of international regulations and labor costs.

Another very large share of the costs of long haul flying is the cost of ownership for the asset. Long haul airliners are produced in much less abundance than short haul aircraft, and the orders placed by airlines and lessors are very well fitted to actual demand. Huge speculative orders that have been witnessed in the short haul market are virtually non-existent in long haul airliners, driving asset values and direct derivatives of it such as leasing rates and insurance premiums.
The overall requirement for long haul aircraft is generally smaller in LCCs than in legacies due to the absence of mega hubs, which drive a lot of the legacies’ traffic. Smaller orders also tend to get much smaller discounts, thus reducing the potential for saving on ownership costs the way LCCs have managed to do on short haul routes.

Other costs arising on long haul flights, such as enroute and airport fees, are also difficult to manage – due to the natural monopoly position of many international airports, there is little potential in reducing fees by choosing a more remote airport, which Ryanair has become famous for in Europe. The large international airports also come with other drawbacks, such as sometimes sky high slot costs and congestion, reducing the potential for maximizing asset utilization even more.

Point-to-point reaches its limit in long haul flying

Long haul traffic has traditionally been funneled through hubs. It is general consensus that most long haul flights need connectivity on at least one end, optimally even on both.

Current LCCs operate mostly using a point-to-point business model. Airline such as Ryanair do not allow connecting flights, and even trying to construct one with several bookings is difficult as schedules are not matched to enable connections.

A point-to-point model reaches the limit of its potential in traffic flows. Only the world’s top city pairs generate enough traffic to warrant a non-connecting long haul flight. To match capacity and demand (necessary to achieve high loads at good yields), LCCs without connectivity would have to turn down frequencies on a route to much lower than daily. This however would make the offering very unattractive for business travelers, leaving only low yielding leisure traffic for the offering.

Those LCCs successful in long haul flying have realized this and have developed a variety of models to enable connectivity. The most prominent example for this is AirAsiaX, which does not only enable connections in its Kuala Lumpur hub, but also in many destination markets where it has joint ventures flying under the AirAsia brand. This is expressed in the share of 47% of passengers on AirAsiaX flights that are connecting to another flight on either end.

To achieve the same, a carrier like Ryanair would not only have to build hubs, an activity with a level of operational complexity where it has zero expertise. The airline would also have to redo all scheduling in those markets and potentially even find an American partner airline to do the same.

LCCs and legacies converging in long haul offering

This focus on connectivity in AirAsiaX is symptomatic of the carriers’ general departure from the classic LCC model, which is also expressed in the airlines’ adoption of real business class seats and a loyalty program. LCCs and legacies converge towards each other. The LCCs generate their traffic largely by diverting traffic from the more expensive legacies. This model will face severe scaling issues as uncontrollable costs rise (especially fuel), as diverted traffic will not tolerate sizable price increases without reconsidering the formerly more expensive choice. Recent studies have also shown that service is once again becoming more important for travelers, despite price remaining the number one decision criterion.

The 60% cost reduction that LCCs were initially able to achieve on short haul cannot be achieved on long haul routes, and the savings potential will become smaller in the future, leaving little space for real low cost long haul.

Image courtesy of dpa

A330neo – the plane Ryanair has been waiting for?

Ryanair has been said to be mulling an entry into the long haul market for quite some time now. Speaking at the World Low-Cost Airline Congress last year, Michael O’Leary made those plans more concrete when he put out some details.

According to this address, Ryanair would start a point-to-point network, initially flying from three European cities to three American cities with a fleet of seven aircraft, and then adding the same every year until a fleet of 40-50 aircraft is reached; with the network growing to up to 14 destinations on each side of the Atlantic.

Said O’Leary: “The prices on long haul flying are too high, what is needed is a clean sheet, using more efficient and lower-cost aircraft” adding that “this can’t happen until we get some planes.”

Well, those planes might have just arrived.

A330neo seemingly ideal for Ryanair

At the 2014 Farnborough Air Show, Airbus launched the re-engined version of it’s successful A330 twin engine widebody. The A330 is already popular with low cost operators, and it’s even more economical reiteration might make it just perfect for a Ryanair long haul venture.

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Of all long haul airliners available today, Ryanair is likely to utilize an efficient twin on the smaller end of the spectrum for its point-to-point approach, focussing on lowest possible CASM.  This means that most likely, Airbus A330 or Boeing 787 are the aircraft of choice. The A350-900, which is now the smallest A350 available, has much range capability Ryanair is not going to need and is thus not a probable choice.

The A330 just became a lot more appealing when Airbus launched the re-engined A330-800 and A330-900 with new engines and several other optimizations.

Ryanair is only planning Europe to North America services and will hence not need large range reserves. The A330neo will be able to do most, if not all, transatlantic missions from Western Europe without any passenger load restrictions, while the 787 is capable of much longer flights, a capability Ryanair does not require.

Proposition of A330neo makes 787 unattractive for likely Ryanair mission profile

Airbus claims that the A330neo will have 12% lower trip costs and 14% lower CASM compared to the A330 it is posed to replace.

This will, according to Airbus, lead to cash operating costs of the plane which are 1% lower than that of the Boeing 787 and 7% lower total cost, which includes cost of capital.

This indicates that the A330neo is especially competitive in the cost of capital category. This is reinforced by the assumed lease rates, which Airbus along with Air Lease Corporation expect to be around USD 1.05 Million for the A330-900 while the 787-9 costs around USD 1.25 Million, despite higher list prices of the A330neo.

The comparative numbers Airbus provides are especially relevant because the utilized 4,000nm mission is likely to be around what a typical Ryanair transatlantic crossing would be like.

Timing may not be optimal for Ryanair

Ryanair’s Michael O’Leary has said last year that he would want to start long haul flights in 5 years at the earliest, a timeline very much consistent with the A330neo’s EIS around 2018/2019.

He has however also stated that he would wait for the next industry downturn before ordering; in order to realize the most favorable pricing. He expects the ME3 and ensuing overcapactiy to lead to that slump, and while some (including the author) also expect this to hit some day, it is not yet anywhere to be seen.

Long haul services by Ryanair will likely still remain a daydream (or nightmare, for some) for quite a few years, but the right plane is there now. If O’Leary does not react in due time, his main complaint (lack of availability) for current planes will become valid for the A330neo also as the production line fills up many years into the future.

 

 

Skymark A380 deferral likely linked to operational hurdles

Most recently, Japanese budget airline Skymark (BC) announced that it would delay the introduction of its A380 aircraft for problems arisen on interior fitting. The airline has ordered 6 frames for use on trunk routes from Tokyo. New York JFK has been announced as the first destination, with Paris, London and Frankfurt to follow as more planes arrive.

They are to be configured in a particularly low density configuration, with 280 fixed-shell Premium Economy seats and 114 angled lie flat Business Class seats for a total of just 394 seats

However, considering the circumstances, it is very likely that the interior-delays are just an arranged excuse for the carrier to defer delivery in the face of severe problems unaddressed.

Wrong airport

A major problem for Skymarks A380 operation is the Tokyo airport system, which largely splits domestic and international traffic between its Haneda and Narita airports. Skymark, Japan’s third largest airline, has a sizeable domestic operation in Haneda. However, it is impossible for the airline to use the A380 out of Haneda as well. While authorities have allowed limited daytime long haul operations out of Haneda lately, Skymark did not gain any of the slots awarded earlier this year. Another slot contingent is unlikely to be distributed for some years still, until the 2020 Tokyo Olympics. At any rate, Skymark would not be able to utilize these daytime long haul slots in the desired way because Haneda bans the A380 during the day, citing congestion concerns as the A380 requires greater separation to following traffic.

The A380 may be used from Haneda in the late evening, this would however create unacceptable arrival times in the middle of the night at the destination airports.

Skymark would, however, have domestic feeder traffic in Japan in this case, something it completely lacks in Narita. The carrier even announced in February 2014 that it would cut domestic services in Narita down to 3 destinations (down from 7) due to losses incurred there. Skymark will need to reassess the decision in order to facilitate connections to its international departures or will have considerable problems filling their A380s.

Problems on both ends

Lack of feed is not an exclusively domestic problem for Skymark. The airline also lacks partnerships with airlines in the planned destinations to feed the flight. Possibilities in New York consist of Delta and JetBlue, and other Skyteam members and unaligned airlines elsewhere due to the lack of a Skyteam presence in Japan.

However, options in Europe will be much thinner than in New York. The best options would be offered in Paris CDG, with local Air France also being a Skyteam member. Air France does have a codeshare agreement with oneworld’s Japan Airlines already though, casting doubt on whether or not they would be interested to enter a partnership with the newcomer.

Options in London and especially Frankfurt are especially dire. In Frankfurt, there is no airline except Lufthansa that has a short haul operation even remotely able to feed an A380 flight. However, as a Star Alliance member and with its extremely successful Joint Venture with ANA, Lufthansa has no interest to cooperate with Skymark.

A look on currently operated A380 routes reveals that even large network carriers only operate the plane on routes where there is sizeable feed on both ends via partnerships. The only major exception, Emirates, operates on a completely different business model and allows for no comparison to be made.

Skymark is thus lacking feed on both sides of the planned routes, a major problem for the carrier, especially after relations with former majority owner H.I.S., one of Japan’s largest travel agencies, cooled down.

Skymark who?

Another problem for Skymark is the lack of brand recognition abroad. While brand recognition of Japanese airlines has always lagged behind that of other airlines in the destination markets, Skymark is a complete non-entity to travellers in America and Europe. Japanese airlines have traditionally been able to rely on a strong bias of Japanese travellers towards Japanese airlines, but hoping for this on new routes starting with the largest plane available and a very limited network seems like a bit of a stretch.

ANA and JAL have been able to charge a premium on that bias, but JALs recent significant reduction in capacity due to bankruptcy indicates that this segment is already very well served by the two players. It might thus prove a significant error of Skymark’s to also enter the long haul business in the premium segment.

The lack of brand recognition will prove an additional hurdle in attracting foreign travellers.

Other LCCs entering the long haul market have chosen a very different approach, with planes on the smaller end (787, A330) and high density configurations to entice passengers with low fares. While it is unclear if this will lead to great success for Norwegian and others like it, it is a far less risky endeavour than what Skymark is trying.

Skymark is also likely lacking corporate contracts, which are instrumental for airlines to fill large premium cabins. This situation is unlikely to change materially, considering Skymarks insiginificant international network even at full deployment of all ordered A380s, which makes it unattractive compared to JAL and ANA.

Grim skies ahead

Without feed and brand recognition, Skymark would likely face astronomical operational losses from their A380 operations. The company is not large enough to easily absorb those losses for even a limited time, let alone an extended period. Delaying delivery was hence the only way to deal with it in the short term.

Should Skymark not be able to alleviate a good share of the problems in time, there will likely be further delays or even a cancellation of the order as a last resort.

Note: Image courtesy of Airbus

Why the CSeries doesn’t sell

Since its launch in 2004, Bombardier’s CSeries has been problem ridden. Dropped at one time in 2006 due to a lack of orders, it was picked up again in 2009 and has since seen important milestones, such as the first flight in September 2013. But problems have haunted the program since its inception, with delays mounting and orders lacking. Most recently, the CSeries has suffered another backdrop when flight testing had to be arrested after one of the planes newly developed engines caught fire last week. Airbus will likely watch the incident closely as Pratt & Whitney’s PW1000G will also be mounted on the European airframers re-engined A320neo.

Orders lacking both quantity and quality

The CSeries received its first firm order in March 2009, when Lufthansa converted a previously signed Letter of Intent for 60 frames into a firm order for 30. The planes will be used to replace ageing Avros in its subsidiary Swiss’ regional fleet.

This order remains to this day the only significant order placed by a large legacy carrier. Since then, Bombardier has only managed to reel in mostly small orders from oddball carriers such as Iraqi Airways or London based startup Odyssey Airlines. Other orders are conditional, such as the one from Canada’s Porter Airlines, which is reliant on the Toronto City Council approving an expansion of the cities City Centre Airport (YTZ).

The programs largest order to date, a commitment for 40 frames signed by Republic Airways, has become highly questionable. While the exact conditions are not known, the Indianapolis-based airline has dropped the plans for which the order was originally made, casting public doubt on the future of the order. Republic Airways is going to focus once again on flying regional services on contract for larger airlines, a business in which it can’t utilize the CSeries as it is too large according to many airlines’ pilot union contracts.

Other than Lufthansa, Korean Air (KAL) is the only major international airline that has ordered the CSeries. The plane is also not enjoying particular success with lessors, who have much more significant commitments for planes competing with the CSeries. To date, Bombardier has been able to collect 203 firm orders for the plane along with 152 options, a far cry from the airframer’s goal of attaining 300 orders until the plane’s entry into service (EiS), which is still scheduled for the second half of 2015 after last week’s incident.

It’s just missing something

The CSeries is aimed at the lower end of Airbus’ and Boeing’s narrow body families, the A318/319 and the 737-600/700. Being smaller versions of larger jets, the aforementioned have always suffered from lackluster economics compared to their larger siblings, having to carry around many tons of structural weight unnecessary for a plane of their size.

However, while Bombardier was busy designing the CSeries, the ‘sweet spot’ in the narrow body market shifted. When the plane was conceived, the 737-700 and A319 accounted for a serious fraction of their respective families’ sales. This has since changed. Gradually over the past years, the share of these variants has detoriated in favor of the base model or even larger variants such as the A321.

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As can be seen above, deliveries of A319s were at their peak both in absolute and relative terms in 2005, around the time when the CSeries was drafted. The A319 was actually just short of accounting for half of all A320-family aircraft delivered in 2005. Since then, its numbers have dropped. In 2013, there were only 38 A319s delivered. Only 7.7% of all A320s were A319s at that point, after their share of deliveries dropped continuously since peaking in 2005. Larger members of the family, however, were in an upwind. The base models’ share of deliveries rose steeply, and even the stretched A321, a niche product in 2005, now accounts for aprox. one in five deliveries.

Due to the A319s unneeded structural weight, its trip costs are not significantly lower than those of its larger siblings, making it highly unattractive for airlines not requiring its range on long and thin routes. It is exactly this phenomenon that Bombardier had embraced as the CSeries business opportunity.

However, airlines did not follow Bombardier’s view on the issue. One of the reasons for the A319s dropping share is not necessarily a perceived lackluster performance in absolute terms, but much more so the relative ease with which airlines are able to recoup the A320s and A321s slightly higher trip costs by selling extra tickets as demand for air travel surges.

Hefty price tag

Bombardier claims 20% lower fuel burn compared to its competitors, and 15% lower cash operating costs; feats that make it the best-in-class aircraft according to Bombardier. The plane has been lauded by airline managers and lessors all across the board, including major players that did not end up ordering the plane, such as most recently Air Canada. Aircraft leasing legend Steven Udvar-Hazy said the plane was good, yet “something’s missing, I can’t explain it.”

In fact, Bombardier has posted a rather hefty price tag for the CSeries, with list prices ranging from USD 58 to 67 million. So far, Bombardier has been said to be very reluctant to grant sizeable discounts on the list prices, something both Airbus and Boeing routinely do. While list prices for the 737and A320 family are higher than the CSeries’, a different discounting practice is likely to have played out to Bombardier’s disadvantage, leaving carriers with the choice of buying larger planes with higher revenue potential for virtually the same prices as the CSeries.

On the lower end of the scale, Embraer is offering the E-195, which is sized in between of the CSeries models, at a much lower price. The E-195s list price is currently at 47 million, while the slightly smaller CS100 is posted at 58 million, a hefty markup of 11 million or almost one quarter. Both prices are not factoring in any discounts.

The unattractive price also explains why lessors have been reluctant to pick up the CSeries, with the purchase price directly translating into the lease rate. At times when an A320 can be had for USD 300,000 per month, it is unattractive for airlines to lease an aircraft with smaller revenue potential for the same price or even more.

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What the CSeries needs to succeed

To turn the CSeries into a commercial success, Bombardier will not only have to offer larger discounts on the aircraft. As is shown by Republic’s consideration of a cancellation, Bombardier will depend on the American legacy carriers’ ability to persuade their pilot union groups to allow larger planes at regional operations. A change in these policies could lead to a significant surge in orders for the CSeries.

Anything else is unlikely to lead to material sales numbers as the market does not seem inclined to pay a premium for the CSeries’ new technology. Brazilian airframer Embraer has chosen to re-engine the current E-Jet offering. This will save costs both in development and in manufacturing, enabling Embraer to offer a price lower than Bombardier’s for an equivalent product, both in terms of size as well as operating economics. The E2 families launch sales are already just short of surpassing all the sales the CSeries was able to garner since its launch.

It is likely Embraer’s path will prove the more successful one.

 

Note: Title image courtesy of Bombardier

Gulf Carriers and Subsidies – What’s truth, what’s fiction?

For years now, European and American Legacy Carriers have complained about the Middle Eastern airlines. They are, claim the legacies, subsidized to the brim and are unfair to compete with.

Emirates has combatted such accusations. According to President Tim Clark, the Dubai (DXB) based airline is quite the contrary, completely unsubsidized. Clark has suggested that it is not the Middle Eastern airlines that are subsidized, but the legacies themselves are, and quite heavily so.

The following will compare the cost structure of Emirates, the only Middle Eastern airline that posts its reports online, and Lufthansa, one of the Middle Eastern airlines’ most outspoken adversary.

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Most common myths about the ‘ME3’

One of the most common beliefs held by Europeans and Americans alike is that the Arab carriers get their jet fuel for free or at heavily discounted rates.

This is, however, false. In fact, Emirates sources its fuel from the same companies that all other airlines buy it from: BP, Shell, Chevron and a few others. While there could theoretically be an incentive in place for the local fuel providers to lower the price for Emirates in exchange for the license to serve the airport, there is no evidence of such a practice taking place. Emirates is likely receiving a volume discount in DXB, but that is normal for all airlines in their hubs as they buy huge amounts of fuel.

In fact, fuel costs make up for a much higher share of revenue for Emirates than for Lufthansa. While Lufthansa’s passenger operations had costs for fuel equivalent to 28% of revenue, while Emirates had a share of 37%.

This difference is actually telling us more than just the obvious – as it is stated in relation to revenues. The fact that Emirates still manages a slightly higher operating margin than Lufthansa leads to the conclusion that there have to be cost advantages, but are they due to subsidies?

Staffing is a problem for Lufthansa

One of the largest expenses position for both airlines is the staff roll, and this is where the first major difference to Emirates’ advantage comes into play: There are no taxes in Dubai. None. Nada. Zero. Well, there are some, but none of them affect Emirates or its employees.  The salary expense for Emirates is the same amount the employee gets to take home – something employers in Germany can only dream of. There are also no social security charges, but Emirates does provide voluntary benefits to attract workers.

What counts is, however, the bottomline. For Lufthansa, every employee costs the company 76,830 euros per year. For Emirates, an employee only costs the equivalent of 49,160 euros – a difference of 56%. Lufthansa dishes out 18.1% of its revenue for its workforce, Emirates’ employee costs are much lower at 12.4%.

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Different fleet structure

A major difference between Lufthansa and Emirates are their fleets. And I am not talking about the fleet make up by type, but about who owns the aircraft.

Of Lufthansa’s 622 aircraft, a hefty share of 90% is owned. Only 4% are on an operating lease and another 6% are on finance leases. Emirates is quite the opposite here. Of 205 aircraft, only 7% are owned. But 57% are on operating leases and another 36% are finance leased.

This way, 96% of Lufthansa’s aircraft end up on the companies balance sheet. For Emirates, this share is much lower at 43%. Still, Emirates has higher depreciation expenses in relation to revenue at 7.8% compared to Lufthansa with 6.1%. This is mainly due to the higher average age of Lufthansas fleet. Many aircraft have been fully depreciated already. Emirates’ fleet on the other hand is much younger and contains many fresh capital leases which drive the depreciation expenses up.

Emirates also has to pay for the high amount of operating leases, a sum that equates to 7.9% of the airline’s revenue, while Lufthansa only pays 0.03% for this.

So, can this be correct? Yup. Emirates actually has higher costs for it’s gear than Lufthansa. Please bear in mind though that Lufthansa makes up for this partly by having to pay interest on loans and bonds it uses to refinance its cash outlay for aircraft purchases.

Also, Lufthansa’s older fleet costs more in maintance (7.4% of revenue compared to Emirates’ 2.6%).

Where the cookie crumbles

So, those are some pretty strong differences between the two carriers. Some are to Emirates’ advantage, some are to Lufthansa’s advantage. But those were small change compared to what comes next.

And this is: Fees. What’s that? Airlines pay fees and charges for several things. They pay them to be allowed to fly over a certain country, to pay for Air Traffic Control. The pay them for landing and parking at airports. And they pay them for ground handling and related tasks. And this is where the real difference is hidden:

Charges and fees are actually the second largest expenses position for Lufthansa at 20.9% of revenue. For Emirates, it is only the third largest position at 10.4%.

What are the reasons for this? One might think that Lufthansa’s shorter average sector length plays an important role here. Due to its large amount of intra-EU short hops, Lufthansa pays for more landings than Emirates does and has to pay high airport fees for much shorter flights.

But that’s only part of the truth, as several factors offset this effect:

1) Long haul flights accumulate more airspace fees as they overfly more countries.

2) Airports charge passenger fees in sector length brackets: Long haul passengers face higher charges. A large share of Emirates’ flights are in the top bracket.

3) Landing fees and other airside charges are subject to the planes weight. As Emirates’ planes are exclusively heavy widebody airliners, the airline pays higher fees for landing, take off and parking.

So, what’s the real reason for this? The solution lies in the airlines respective home bases. Charges and fees are much lower in Dubai than they are in Europe. Half of Lufthansas’ flights start in an airport that is much more expensive than Emirates’ Dubai. Many flights also stay in Europe and thus also land at a rather expensive airport. In comparison, Emirates has a very high share of flights landing in Asia, which is notorious for very low landing charges – sometimes notably lower (e.g. Kuala Lumpur (KUL)) than even in Dubai.

So – subsidized or not?

Strictly speaking, Emirates is not receiving any direct subsidies from Dubai’s or the UAE’s governments. And less strictly? Well, as can be seen above, Emirates does benefit massively from its location.

There are no taxes levied on the company. This in turn means lower staff roll expenditure and no obligation to pay any corporate taxes in Dubai.

Emirates also profits from cheap access to infrastructure. As Emirates likes to point out, they are paying the same fees in Dubai as any other airline landing there. But as a home carrier, those low fees make up a large share of the overall fee structure paid by Emirates throughout the network, leading to massive savings compared to European and American airlines.

The low cost of infrastructure and lower average wages (partly causing the lower cost of infrastructure) are also attributable to the practice to hire workers from South and South East Asia, a practice common in the Emirates. The conditions in which these workers are employed and housed have drawn criticism because of low standards of hygiene, personal freedom and harsh labor conditions. Some investigative journalists have described this as nothing short of slave labor from a Western point of view.

Another factor keeping the ME3’s labor cheap is the Emirates’ ban on unionization. Many Western carriers are haunted by notoriously strong unions.

All of this in conjunction leads to an environment as friendly as possible to Middle Eastern airlines’ business model, a construction only possible for a state run enterprise such as Emirates and Qatar. Privately held airlines in Europe and America will continue to have difficulties coping with this unlevel playing field. In fact, some governments have even recently imposed higher taxes on aviation. Airline tickets are now higher taxed in some western jurisdictions than other goods like alcohol or tobacco, on which taxes are usually levied to discourage use.

Overall, both Europe and America have policies in place that rather penalize aviation. It is, thus, plainly wrong  of Emirates’ Tim Clark to tell off the European airlines for receiving subsidies. Emirates not being granted access to more German airports is only small consolation for airlines like Lufthansa given all the other policies in place, like the German aviation tax.

Air Berlin’s hardships and Etihad’s intransparent investment strategy

Air Berlin’s story certainly hasn’t been one of success lately. Since 2008, Germany’s second largest airline has posted continuous operative losses for 6 consecutive years now.

From the late 1990s, the airline had experienced a decade long period of tremendous growth, accelerated in the late 2000s by a string of high profile mergers and acquisitions of, among others, dba and LTU.

But since reaching it’s peak in 2011 of 170 aircraft and over 35 million passengers flown, the airline was forced to shrink significantly to reduce costs. In that year, Air Berlin posted a consolidated loss of 420.4 million euros, compared to 106.3 million in the year before, despite a significant rise in ticket sales.

At that point, Air Berlin was no longer able to go on with business as usual.

Etihad bailout

Enter Etihad. The Middle Eastern carrier, already holding a 2.99% stake in Air berlin, increased this stake to 29.21% for a total of 73 million euros, becoming the airline’s largest individual shareholder.

Since then, Etihad has been the main supplier of cash for the ailing German airline. Etihad has bought several bonds from Air Berlin, among them a convertible bond for 300 million euros sold to Etihad only last month; and bought other parts of the airline, notably a 70% stake in its frequent-flyer program, Topbonus, for 184.4 million euros in 2012, leading to a narrow consolidated profit for the airline for the first time in years, despite significant operational losses.

Despite ending 2012 with a slightly positive Free Cash Flow, Air Berlin’s problems are far from over. The airline is still burning cash at an incredible speed. Its cost-cutting measures are seemingly evaporating on the spot.

The airline posted a consolidated loss of 315.5 million euros for 2013, after delaying its report for weeks while management was trying to raise additional cash from Etihad as Air Berlin had negative equity of 186.1 million euros at that point, with net debt reaching an unprecedented 796 million.

 

Recapitalization successful, but…

The airline has since been recapitalized by the issuing of several new bonds, most notably a cumulative perpetual subordinated convertible bond of 300 million euros to Etihad to resolve the negative equity situation. Air Berlin has also issued 2 non-convertible bonds for a total of 252 million euros, 90 million which stem from a bond issued in Swiss Francs and paying a lower coupon of 5.625% compared to the 6.75% of the bond issued in euros.

Air Berlin said it would use 150 million euros of the proceeds of those two bond sales to finance operations and the rest to refinance current debt.

These most recent bond sales were significantly cheaper for the airline than its previous collectings, which paid as much as 8.25% and 11.5% of coupon. Air Berlin CFO Ulf Hüttenmeyer said the airline was expecting investors to convert 100 million of this debt into longer running papers from the latest offering. However, it was unable to attain this goal as only 12.63 million were replaced, showing investors doubts over the airlines future prospects.

EU investigates Etihad’s stake 

Further doubt concerning Air Berlin’s future is raised by the European Union, which is currently investigating Etihad’s engagement to assess whether or not the Middle Eastern carrier is controlling the airline.

While Etihad is not in breach of EU rules on foreign ownership, which command a majority stake in a European airline must be held by EU individuals, the Commission is investigating if and how Etihad might control the airline despite holding a minority stake only.

The EU said it is considering 5 airlines and their foreign stake holders in this process, with Etihad featuring prominently and multiply.

EU-Commissioner Siim Kallas’ inquiry about the airlines ownership structure coincided last month with speculation about a possible delisting of Air Berlin’s stock and a conversion of the company, which is currently a British PLC, into a German GmbH in combination with Etihad raising its stake to 49.9%. While the Executive Board of a PLC is not legally mandated to carry out directions from the companies owners, a GmbH’s executive is directly subordinated to the owners and thus much easier to control.

This conversion would have further strengthened the EU’s case and was not ultimately executed.

However, action from the EU is still in the realm of possibilites due to Etihad’s repeated major involvement in resupplying the Air Berlin with fresh cash.

Air Berlin Boeing 737-800 (Image: Air Berlin)

Air Berlin is a money sink

Another big question mark is raised by the outlook for Etihad as an investor. While Etihad could theoretically continue to supply cash to Air Berlin in the same way as last time (if the EU takes no action), it becomes clearer and clearer that Air Berlin has become a significant money sink for Etihad, which has now supplied Air Berlin with a sum exceeding 800 million euros through various bonds, loans and equity/asset acquisition.

Concerns have been raised by the German government about the legality of the most recent convertible bond, which might be in breach of European Laws. Air Berlin denied such claims and considers it’s recent bailout to be in line with the law. The German government was not willing to give any further comments.

After the recent recapitalization, Air Berlin’s revised annual report’s cash statement stands at 673 million euros. At last years cash-burn rate, this money will be gone in no time. The airline is bleeding cash at a rapid rate, losing a total of 491 million euros of cash last year, only partially remedied by the sale of assets and bonds, leading to a net decrease of cash and cash equivalents of 103.2 million.

The airline’s Q1/2014 net loss rose to 210 million euros compared to previous year’s 196 million, biting off a significant chunk of the recently infused cash.

Despite attempts to change this with various cost-cutting measures, there does not seem to be any noticeable improvement of the airline’s situation. The long term survivability of the airline is therefore highly questionable. It is becoming more and more obvious that the airline will need a full scale makeover to become profitable again.

Major restructuring unavoidable

This includes a revision of the carriers business model, which it is currently advertising to potential investors as a ‘complementary business model’, aimed at business passengers, private individuals and tour organizers. The airline states on its Investor Relations website that it is currently in the process of transforming into a full service carrier, utilizing its global oneworld-network as well as its partnership with Etihad, something it calls a ‘clear strategy’.
The airlines management does however seem very reluctant or unable to significantly reduce the carriers footprint in one of it’s core markets. Its continued involvement in traditional holiday traffic to the Mediterranean, where the airlines roots lay, is contradicting Air Berlin’s transformation to a full service network carrier. A further construction site for the airline are its two hubs, Düsseldorf (DUS) and Berlin (TXL, to be BER), which are geographically close to each other and have a very large share of overlapping services.

The carrier has said it would return to capacity growth for 2014, after a 5.1% cut of available seat kilometers (ASK) in 2013. It is now planning to grow it’s number of seats by 3%, but the outcome of this is questioned by dropping load factors in 2013. Last year saw Air Berlin’s revenues down 4%, but costs even rose by 3.5%, thus failing to match the drop in revenues and aiding in returning the airline to it’s acute state of emergency.

In an attempt to remedy it’s decrepit financial state, Air Berlin has created the new posts of Chief Restructuring Officer filled by Marco Chiomperlik and Chief Strategy and Planning Officer, which will be filled by Etihad’s John Shepley until a permanent candidate has been found.

Air Berlin CEO Wolfgang Prock-Schauer said mid-May that the airline was working on a radical restructuring but did not go into details, which he said will be publicized in the coming months.

The airlines performance and restructuring in the coming two years are now crucial to its chances of longer term survival.

Regulators scrutinizing Etihad’s investment portfolio

Etihad is facing regulatory trouble not only concerning it’s involvement with Germany’s Air Berlin, but also with it’s other European investments.

Those are Swiss based Darwin Airlines, recently rebranded to Etihad Regional and Air Serbia (formerly JAT). The EU Commission has also said it would closely monitor any possible involvement of Etihad in Italy’s chronically loss-making Alitalia, which it has allegedly been mulling to merge with Air Berlin.

While Switzerland, which is Darwin’s home country, is not part of the European Union, it is still subject to previously mentioned EU ownership regulations through a treaty between the two entities. After a capital increase, the procurement of new aircraft and massive changes in the airlines route network as well as a rebranding to Etihad Regional, the EU has grown sceptical about the level of influence Etihad has over Darwin Airline.

Etihad was not yet able to leverage it’s involvement with Darwin because the Swiss BAZL has not yet approved it’s cooperation agreement with each other. The regulators have stated that this approval is directly linked to a review of foreign ownership and control at Darwin.

It is unclear what Etihad’s plans are with Darwin should they win the regulator’s approval.

Air Serbia Airbus A319 (Image: Air Serbia)

Etihad has also purchased a 49% stake of JAT, which has subsequently been renamed to Air Serbia and received a complete fleet overhaul.

While Serbia is also not a member of the European Union, it is currently negotiating to join, which it hopes to do by 2020.

Air Serbia has recently announced plans to start long haul routes in fall 2015 to Chicago and Toronto. However, it is very uncertain to say the least if the US Department of Transportation will allow Air Serbia to move forward with this, as it has raised similar doubts about foreign ownership and control as the EU has raised over Etihad’s stakes.

Etihad had received a blow from the DOT earlier this year when a try was made to codeshare Etihad’s US flights with Air Serbia, an attempt that was foiled after a complaint from the American airlines due to unreasonable backtracking.

The DOT also said in it’s denial of the codeshare that Serbia did not have a bilateral Air Service Agreement, a situation that has not changed since.

Ultimately, the outcome of the diverse regulatory issues will determine which way Etihad will be going in the future. A clear decision against the legality of Etihad’s stakes could likely spell doom over several ailing carriers.

 

Note: Images courtesy of Etihad, Air Berlin and Air Serbia, respectively.