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Deutsche Lufthansa LHA S
January 11, 2016 - 3:32pm EST by
jso1123
2016 2017
Price: 14.65 EPS 2.6 1.5
Shares Out. (in M): 465 P/E 0 0
Market Cap (in $M): 7,400 P/FCF 0 0
Net Debt (in $M): 2,500 EBIT 0 0
TEV (in $M): 10,100 TEV/EBIT 0 0
Borrow Cost: Available 0-15% cost

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  • Airline
  • Germany
  • Cyclical
 

Description

Summary
LHA GR is the largest legacy airline in Europe. It does about €32B in revenue and €3.5B in EBITDAR. LHA
is facing major structural issues due to its high legacy costs, especially with regard to union-related labor
costs, and increased competition from low cost carriers (LCCs) and Middle East carriers (Etihad, Qatar,
Emirates) that are adding capacity to LHA’s core routes.
 
Background
LHA has created very little value since going public in 1994 and faces a more challenging competitive
situation today than ever before.
 
 
 
LHA was state-owned until 1994, when it was taken public, and has never really been run like a business.
It is fraught with high legacy labor costs from its unionized workforce, a big pension deficit, inefficient
intercompany service arrangements, and it has one of the oldest fleets. LHA is currently getting
squeezed on both ends due to increased competition resulting in overcapacity in both its short-haul and
long-haul markets.
 
LHA’s core short-haul European business is facing pressure from LCCs (RYA LN / EZJ LN) who are adding
more capacity to LHA’s core German market than ever before and charging significantly lower fares (at
least 30% below those found at LHA). On long-haul routes, where LHA has historically made its money,
LHA is getting disintermediated by Middle East carriers (Etihad, Emirates, and Qatar) who are adding
excessive amounts of capacity to LHA’s long-haul routes and charging about 70% the price of flying with
LHA while offering a better flying experience (newer planes, nicer amenities, more direct flights, etc.).
 
LHA decided to try to grow their way out of the problems by creating their own LCC (Eurowings,
formerly called Germanwings) to compete with LCCs. Eurowngs operates the same planes as the rest of
LHA’s legacy passenger business; however, the planes are repainted and flown by non-union pilots. In
short, LHA’s LCC efforts have been a colossal failure. It charges significantly more than other LCCs and
has pissed off the unionized pilots from LHA’s legacy passenger business who, as a result, have been
striking on and off for the past year and a half (resulting in material strike costs). There will likely be
more strikes before LHA either gives significant concessions to the pilots and/or scraps the LCC strategy.
- For reference, Air France previously started a LCC and ended up scrapping the strategy after
racking up €500M of strike costs.
 
 
 
 
Structural Disadvantages
LHA is structurally disadvantaged due to its high legacy cost structure and recently increased
competitive threats that will force it to relinquish any fuel savings in the form of price reductions. This
will result in continued margin pressure and make LHA unable to achieve consensus expectations.
-Yields are already negative and will continue to decline as ultimately LHA passes on all fuel
savings.
 
 
 
Margin of Safety
- LHA is a cyclical business with HSD ROTC, a weak balance sheet (2.5x adj. net debt / EBITDAR),
and a €7B pension deficit.
- LHA’s management has a relatively poor track record of capital allocation.
o They’re now throwing good money after bad with the failing LCC strategy.
o They’ve spent over €6B in pension contributions over the past decade and yet the
pension deficit has only grown. The contributions to the pension plan are determined by
company policy rather than German legal requirements.
 
 
 
 
- LHA’s has one of the highest cost structures and very little room to cut costs.
 
 
 
 
- LHA’s core German market is ripe for the increased competition as its core airport, Frankfurt, is
underutilized (operating at 75-80% utilization, 65% of which is from LHA) and LCC penetration is
low in Germany and expected to rise in the coming months.
 
 
 
- LHA has one of the oldest fleets.
 
 
 
 
- The majority (~65%) of LHA’s traffic is transfer traffic. Transfer (vs point-to-point) routes are
fundamentally more price competitive and pass on fuel savings more rapidly.
 
 
 
Valuation
- Valuation is the biggest problem with this short as LHA is trading at 5.5x fwd consensus EPS and
4x 2015 Adj. EV / EBITDAR.
o Historic valuation range is below.
 
 
Risks
- LHA trades at a low multiple and is a low margin business. As a result, small re-rates and/or
changes in profitability will materially impact the stock price.
- LHA’s business complex and multivariate, which makes it very hard to get a clean grasp on the
numbers and rely too much on the model.
- Although it’s unlikely that LHA will be able to retain any fuel savings, any fuel savings they do
manage to keep would be a negative to the thesis.
 
- Although splitting up LHA is improbable, valuing LHA on a SOTP basis would make it look cheap.
o See charts below for a segment revenue and profit breakdown.
o However, it’s important to note that 40% of the MRO business is internal, 25% of the
Catering business is internal, and 60% of the IT services business is internal.
 
 
 
 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

 Excess capacity in the European markets manifesting itself with weaker pricing

End of positive estimate revisions from falling fuel

 

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