3D Insight - AACO Insight... · Secondly, while LCCs have driven Intra-European capacity growth at an annual average growth rate of 21% per annum over the last 10 years, the Big 3

ISSUE 14August 2012

3D Insight A Publication by AACO and Seabury Aviation & Aerospace

3D Insight - Issue 14 Page 2

Part One of a Four part series

The Major Airlines Outside of MENA

This is the first article in a 4-part series on the AACO carriers’ major non-AACO competitors. This first article examines the largest source of

competition: Europe’s carriers, with a particular focus on the big three European airline groups.

Background

Fig 1 - Seat capacity breakdown from MENA excluding AACO carriers

Jun’12 seats (K)Jun’12 seats (K)


Over the last 10 years the Big 3 European carriers: Air France-KLM, International Airline Group (predominantly British Airways-Iberia) and the Lufthansa Group, have faced increasing competition in their short-haul markets from the likes of easyJet and Ryanair.

The yields in these markets have fallen and the profitability of their flights has suffered. Accordingly, they have deployed their growth resources into longer-haul markets, among which 10% has been dedicated to the MENA region.

To cope with this new environment, the Big 3 have developed strategies to bring in more revenue, such as advanced origin and destination revenue management systems, short-term fleet assignments to match demand more accurately, and increasing load factors or through alliance and partnerships.

However, economic conditions and competitive intensification in key growing markets have forced these major carrier groups to enact via intensive cost reduction programs. Maintaining costs as low as possible will remain a challenge for the foreseeable future, as for Europe’s long, slow journey through austerity.

The sustainability of Europe’s big three carriers is also tied into their relationships with their regulators.

IntroductionEurope’s Big 3


For the purposes of this article, capacity has been separated into 14 different flows: Intra-EU-27, Norway, Switzerland and Iceland; Russia and the CIS; Turkey; AACO North Africa; AACO Levant; AACO Arabian Gulf; Indian sub-continent and Persia; Rest of Africa; South Asia; South East

Asia; North East Asia; North America; Central America & Caribbean; and South America.

Over the last 10 years, capacity on these routes has grown (as shown below).

Fig 3 - 2006-2011 seat capacity growth from Europe to the world

Overview Total European based capacity has grown by approximately 5% per annum over the last 10 years. The capacity growth has been split between the European big three carriers, the European low-cost carriers, other European carriers, and non-European carriers, as follows:

Capacity Deployment

Fig 2 - Europe total capacity development

Seat departed per annum millionSeat departed per annum, million

1% 7%7%

1,200+53%

1,000

11%

8%

11%

4%23%

800

1,000

34%

11%7%

21%400

600

Ex-Europe - EU carriersEx-Europe - Non-EU carriers

Ex-Europe - LCCEx-Europe - Big 3

35%30%

2005 2006 2007 2008 2009 2010 20112002 2003 20040

200 Europe - LCCEurope - Big 3Europe - Other carriers

Note: Big 3 includes AF-KLM (including AF, KL, EC), IAG (including BA, IB, AO) and LH (Including LX, OS, SN, BD, DE, WW, TV); EU carriers include all carriers domiciled in Europe; Non-EU carriers include all carriers domiciled outside of Europe; Other carriers include all carriers excl. LCCs and the Big.3, with Intra-Europe capacity.Source: Innovata, Seabury analysis.

2005 2006 2007 2008 2009 2010 20112002 2003 2004

26%

76%

125%

34%

62%

7%

10%

84%

13%

Growth (%)

European carrier

Non-European carriers

European carriers

12%76%

40%9% 10%

12%

17%

European Common Aviation Area

Russia & CIS

Turkey

AACO North Africa

AACO Levant

7%

23%

2%0%

-9%

11%

10%

25%

AACO Levant

AACO Arabian Gulf

Indian Sub-Continent and Persia

Africa

South Asia

35%

48%

0%34%

80%

South East Asia

North East Asia

North America

Central America & Caribbean

South America

Note: Annual seat capacity.Source: Innovata, Seabury analysis.

South America


The new environment in the short-haul market has drastically changed the mind-set of the big 3 European carriers.

Firstly, several regional competitors have left the market such as Blue Wings, Air Slovakia, Viking, Malev Hungarian Airlines, and Cimber Sterling.

Secondly, while LCCs have driven Intra-European capacity growth at an annual average growth rate

of 21% per annum over the last 10 years, the Big 3 as a group have remained relatively steady.

IAG (and its predecessors) reduced seat capacity by -29% between 2002 and 2011, +5% for Air France-KLM and +17% for the Lufthansa group. Taken together this represents a growth rate of only 5 per cent per annum.

Fig 4 - Within Europe capacity development

The low-cost carriers have also dramatically expanded the number of direct markets served vis-à-vis the Big 3.

In 2011, the Big 3 offered only a fourth of all city pairs proposed by LCCs, and with only 7% more choices than in 2002 (vs. +200% for LCCs). While numerous small LCCs have expanded in

different regions of Europe, easyJet and Ryanair have been leading the expansion and now count respectively 20 and 51 different airport bases .

The network carriers’ ability to open new routes is, on the contrary, limited by the traditional design of their hub and spoke network and their cost base.

Intra-Europe Capacity


CAGR(%)

1,000

+59%

+21%

1%

800

600AF KLM

LCC

+1%-4%+2%400

AF-KLMIAG

LH Group

+4%200

0

Other FSC & Charter

Note: Big 3 includes AF-KLM (including AF, KL), IAG (including BA, IB, AO, EC) and LH (Including LX, OS, SN, BD, DE, WW, TV); Other FSC & Charter include Medium, small and other FSC, regional and charter airlines. Source; Innovata, Seabury analysis

2004 200520030

2006 2007 2008 2009 2010 20112002

1


Some markets have been less susceptible to low-cost carrier incursions.

This has typically been due to either a strong presence of a network, other domestic or regional

carrier, or due to constraints in airport access or the lack of financial aid to attract LCCs to open new potential routes.

Fig 6 - LCC home market penetration of Big 3 carriers

% of seat capacity offered by LCC% of seat capacity offered by LCC

48%

44%50 UK

Spain

28%

34%

30

40

Germany

Netherlands

23%20France

0

10

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Source: Innovata, Seabury analysis

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Fig 5 - Big 3 vs. LCC non-stop connection

# of city pairs flown by A320 or B737 aircraft familiesCAGR

(%)# of city pairs flown by A320 or B737 aircraft families

3,000

3,500

Daily - LCCDaily - Easyjet & Ryanair

Daily - Big 3

All pairs - Easyjet & Ryanair

All pairs - Big 3All pairs - LCC

(%)

+19%

2 000

2,500

Daily Easyjet & Ryanair All pairs Easyjet & Ryanair

+33%

1,500

2,000

+22%

500

1,000+0%

+22%

+1%

Note: Based on annual capacity, flights with at least 365 frequencies/year. Source: Innovata, Seabury analysis

02002 2003 2004 2005 2006 2007 2008 2009 2010 2011


Fig 7 - Air France vs. LCC and train capacity

This has been historically the case for France which, despite being one of the larger European markets, has managed to limit LCC penetration at only 23% of short-haul capacity vs. the 48% seen in Spain and the 34% seen in Germany.

Another major factor contributing to the limited capacity of low-cost carriers in France is the presence of a high speed train network.

As shown below, on short distances (within 1-2.5hrs), both Air France and LCCs offer limited capacity on routes such as Paris-Lyon, -Nantes,

-Strasbourg or -Lille, whereas on longer routes such as Paris-Bordeaux, -Toulouse, -Marseille or -Nice, air travel represents a sufficient time gain versus high-speed rail.

On these segments, Air France has kept the largest market share. The low-cost carriers have entered the market on routes from the French provinces that overfly Paris. Air France had avoided these routes until recently (e.g. Lyon-Bordeaux, Lyon-Toulouse, Nantes-Marseille, etc.).

LCC and Air France capacity From France to Europe Jun’12 seat capacity

Source: Innovata, Seabury analysis, SNCF.

High speed train (TGV) routes

In response to the low-cost carrier growth, the European Big 3 have acquired or developed their own low-cost subsidiaries, with limited success so far. Both AF-KLM subsidiary Transavia and Lufthansa’s LCC Germanwings have been unprofitable in recent years. However, as part of their 2012 restructuring programs, both carriers have identified these subsidiaries as a key tool to recover profitability on short-haul markets. These three carriers are working to arrive at a cost competitive model that will be needed to recover profitability on this market segment.

Indeed the Big 3 announced in 2012 cost reduction and profit improvement programs. Air France-KLM announced its Transform 2015 program, a 3-year plan, which aims at restoring profitability at the horizon of 2014, via reduction objectives of 10% in unit cost ex-fuel and €2 billion in debt .

The short-haul market will be developed following three axes, the low-cost segment on one hand, the two others are the mainline activity from Paris CDG as well as Marseille, Toulouse and Nice, and, a regional holding, which will regroup the group subsidiaries, Regional, Britair and Airlinair, offering point-to-point service out of Paris Orly.

Air France-KLM plans to expand Transavia service for its “leisure” traffic out of its hub in Paris Orly, with a fleet expected to grow from 8 to 22 B737 by 2014, but only under the condition that Transavia reduces its costs by 10% . This new “commercial offensive” strategy aims also at improving resource productivity to compete with LCCs. The objective is to serve new routes from Marseille, Toulouse and Nice, offered only several times per week, based on the LCC model.

As shown above LCCs offer only about a third of their routes at a daily frequency, versus half of them for the FSCs, providing more flexibility to serve different routes. Additionally, the aim is again to reach operating costs 15% lower than currently, with regionally based crews and aircraft, homogeneous fleet and accelerated ground time.

Lufthansa launched a companywide cost reduction program early 2012 called “SCORE”. Regarding short-haul market, Lufthansa announced its intention to combine the LH Direct services with the Germanwings operations and reduce administrative redundancy between the two entities, in order to be able to use similar lower-cost business models on short-haul routes .

Finally, Iberia has launched in March 2012 Iberia Express to replace some of its short- and medium-haul routes. After a month of dispute with the Iberia pilot union, the government appointed an arbitrator to confirm the legality of such a new subsidiary and the limits of cost reduction, primarily in pilot wages. While the first element was clearly validated by the arbitrator, the second consideration has been answered but Iberia started an appeal process. Finally, Iberia launched its new subsidiary Iberia Express in October 2011, offering customers a similar product, with a higher seat density, but at a much lower cost. Iberia has also announced plans to make a major restructuring. On the contrary, while purchasing bmi, British Airways sold bmi regional for 8 million pounds to Sector Aviation Holdings Ltd (SAH), and grounded bmi baby from September 2012.


2

3

4


Capacity outside of Europe deployed by the Big 3 European carriers has grown by 14% over 10 years.

The largest flows from the Big 3 hubs are to North America and Asia but capacity to the MENA region, South America, Africa and Russia & CIS has grown by 3 to 8% per year depending on the regions.

Fig 8 - Big 3 ex-Europe capacity growth

The LCC traffic out of Europe has grown by 6% p.a. in average, mostly to the near regions, with which the European Union has more open bi-laterals as in North Africa and Levant.

This traffic is at the far end of the short-haul traffic which fits into an LCC business model. Airlines categorised as “low-cost” such as Air Berlin and LTU also offer increasing service to further destinations such as North Africa or South Asia.

Ex-Europe Capacity

2006 and 2011 Big 3 seat capacity from Europe CAGR (%)2006 and 2011 Big 3 seat capacity from Europe, CAGR (%)

North East Asia+3%

Russia & CIS+7%

Central America

North America+2%

+3%

AACO North Africa-3%

AACO Levant

+4%

Turkey+3%

Central America& Caribbean

+1%

Africa+3%

AACO Arabian Gulf+6%

Indiansubcontinent

-0.2%

South Asia-0.4%


South America+8%


Each of the Big 3 has adopted a differentiated strategy based on their network and partners.

Lufthansa grew by 5% per year between 2006 and 2011 placing new capacity on the Levant, the Arabian Gulf, Russia & CIS and Africa.

On the contrary, AF-KLM and IAG long haul capacity has grown only by 3-4% since 2006.

Therefore capacity deployed to new markets comes partly from a shift from other markets including the MENA region for Air France KLM, and Americas/Africa for IAG.

Fig 10 - Big 3 outside Europe capacity development

Fig 9 - LCC ex-Europe capacity growth

2006 and 2011 LCC seat capacity from Europe CAGR (%)2006 and 2011 LCC seat capacity from Europe, CAGR (%)

Russia & CIS+51%

North America+3%

Turkey+7%

Central America & Caribbean

AACO North Africa+60%

AACO Levant+117%

-13%

Africa-12%

AACO Arabian Gulf

+100%

Indiansubcontinent

-38% South Asia8%



31% 43% 26%% 2011 capacity h

Note: Big 3 includes AF-KLM (including AF, KL), IAG (including BA, IB, AO, EC) and LH (Including LX, OS, SN, BD, DE, WW, TV).Source: Innovate, Seabury analysis.

31% 43% 26%share

Fig 11 - European alliance members in 2012


This European collaboration gives airlines access to a wider network, and to the marketing and sales forces of the partners without the constraints of a

merger or acquisition. Outside Europe, the three alliances group the main players of the Americas and Asia, as well as a few African airlines.

Fig 12 - Worldwide alliance members in 2012

Over the last 10 years, there has been a rapid acceleration of alliance membership as many of the regional carriers in Europe have recognized

the need for partnerships at the periphery of their networks.

Expansion of Alliances

Invited/Future members

Souce: oneworld, Star Alliance and Skyteam, airline websites, CAPA, July 2012.

Unaligned European carriers

Note: Excludes affiliates of membersSource: oneworld, Star Alliance, and SkyTeam; airline websites; CAPA, July 2012


While growing over the last 10 years, the Middle Eastern carriers have built their network around their hub positioned as an ideal connecting point between East and West, competing with the Big 3 European airlines alliances on many Europe to Indian subcontinent and Europe to East Asia flows.

European airlines have seen the development of alliances as a protection against this new competition. They have signed antitrust immunity agreements with the major American airlines and

more recently with some North-East Asia airlines, such as the July 2012 British Airways-Japan Airlines agreement.

These allow partners to agree on offered capacity vs. demand without restrictions but also to limit impacts of bilateral agreements outside Europe, slots and other constraints. Apart from the one with the Royal Jordanian, no antitrust immunity agreement between the Big 3 and a Middle East or North African airline has been reached.

Fig 13 - The current network of antitrust immunities

Multi-company JBA in place JBA in place JBA pending

Source: Company and government websites, Centre for Asia and Pacific Aviation, US Secretary of Transportation, July 2012.

To analyse trends, the MENA region needs to be divided into three sub-regions: North Africa, Arabian Gulf and Levant.

The North Africa-Europe market has seen the LCC share grow by 30% per year in the last 10 years, with all carrier groups growing, primarily driven by the EuroMed open skies agreement between Europe and Morocco in 2005.

While LCCs in Morocco grew by 47% per year in average, the development was of 15% in Egypt but only of 6-7% in Algeria and Tunisia.

Fig 14 - Capacity distribution from Europe to MENA region

Overall the Big 3 have developed their capacity by only 3% per year over 10 years in the region. However, while in Tunisia and Morocco, LCCs but also charter Europe outward competition increased, medium or smaller full service carriers expanded capacity in Tunisia, Algeria and Libya.

The picture in the Arabian Gulf is quite different; the AACO carrier flights into Europe have grown by 18% per annum over the last 5 years, and now occupy 65% of the capacity.


Focus on MENA

To North AfricaSeat departed per annum (M)

To the Arabian GulfSeat departed per annum (M)

To the LevantSeat departed per annum (M)

14

18

1616

143

18

+8% p.a.

17

13.9

16

18

14

10

14

12

2

101

14

4

8

11

2

12 2.6

0.1 1.0

8.9

+13% p.a.

10

12

14

1 0

0 3

2.8

+3% p.a. 6.26

4

8

4.6

2.12.4

4.6

12

7

3

1

6

2

8

0

4

6

8

10.20.91 5 6 0

6

8

4

2.0

1.0

4.8

0.3

2011

1.2

2006

1.0

2 1.8

0 1.01.3

2002

1.5

02002

65

20112006

22.4

1.5 6.0

02006

2

2002 2011

AACOBig 3

LCCs & ChartersOther carriers

42% 39% 19%% 2011 capacity share

Note: Big 3 includes AF-KLM (including AF, KL, EC), IAG (including BA, IB, AO) and LH (Including LX, OS, SN, BD, DE, WW, TV); Other carriers include Medium, small and other FSC carriers.Source: Innovata, Seabury analysis.

Fig 15 - Europe to MENA capacity development by fleet type

The Big 3, aware that their short-haul unit price will keep dropping, are focusing on opportunities in long-haul traffic launching initiatives to optimise the network, redeploy capacity or focus on product quality and innovation.

The Levant region represents a smaller and more fragmented market than do the North African and Arabian Gulf regions.

The LCCs are currently only marginally present but they have been developing their capacity in the region by 40% per year over the last five years.

The Big 3 and the AACO carriers represent only about 40% capacity share, other non-European and European airlines carriers such as Cyprus Airways and Air Berlin are present in this market.

Similar to the North African markets, most carriers deploy narrowbodies from Europe to Levant. They keep widebodies for about 30% of their fleet to serve high density markets such as Damascus or Amman.


To North AfricaDeparted flights (K)

To Arabian GulfDeparted flights (K)

To LevantDeparted flights (K)

120

100

120

100

120

100

80

60

80

60

80

60

43%

60

40 6%2%10%

4%60

40

47%

60

40 39%

43%

24%

20

018%

60%

29%47%15%

6%20

0 9%4% 6%16%17%

47%

10% 11%13% 15%10%41%20

0 1% 4%0%

12%

4% 9%2%18%

43%

Note: NB: Narrowbody; WB: Widebody; Narrowbody includes R-jets and Turboprops. Source: Innovata, Seabury analysis.

20112009200720052003

Big 3 - WBAACO-WBOther carrier - WBBig 3 - NBAACO-NBOther carrier - NB

2011200920072005200320112009200720052003

Revenue Improvement Initiatives


Investment in high-growth markets especially Asia and Africa still provides opportunities. Over the last 4 years, the Big 3 carriers have deployed only 0-3% more capacity towards Asia, Africa and MENA markets versus 10 to 20% from the three major Gulf carriers.

The ability to capture flows to these growing regions will be crucial for European carriers, while they shift capacity from intra-Europe to long-haul markets.

The Big 3 have seen a 0-2% drop in unit revenue each year, alongside the rest of the European flag ship carriers.

Lufthansa, IAG, and Air France-KLM have historically realized high unit revenues. Reducing the exposure to competition from airlines sustainable at a low yield, such as LCCs, or from enabled-high-capacity-growth airlines, such as Gulf carriers, limits the sharp drop of unit revenues.

Fig 16 - Unit revenue performance

Long haul vs. short haul unit revenue development

RASK (€ cents)RASK (€ cents)

14

12CAGR

(%)

-2%

8

100%

-1%

6

8

200720062005200420032002 2011201020092008

Source: Company financial public data, Seabury analysis

200720062005200420032002 2011201020092008

Fig 17 - Expected GDP growth forecast vs. historical seat capacity growth

Constant price GDP growth for 2012-2017 vs. seat growth for 2006-2011 from home to the p g gworld (one direction)

Regions 2012-2017 avg. GDP growth (%)

Asia 6.0% 2% 19%

South Asia 5.9% 0% 15%

Africa 5 5% 3% 16%Africa 5.5% 3% 16%

Russia & CIS 4.2% 7% 24%

MENA 4.1% 2% 10%

South America 4.0% 8% n/a

Europe 2.5% -1% 13%

Note: MENA includes North Africa, Levant and Arabian Gulf; South America includes Caribbean, Latin and South America; Asia includes North East Asia, Indian Subcontinent and South-East Asia; straight average growth between 2012 and 2017; CAGR seat growth.Source: Innovata, Seabury analysis, International Monetary Fund.


Fig 18 - Capacity load factor

Network carriers have achieved an increase of 1% per year in average in load factor, through a combination of tactics to improve their selling practices and improving their revenue management systems.

For many carriers the inventory management is now managed on an O&D basis, instead of the leg – segment basis that has been in use for the last 25 years.

Moving into greater demand segmentation has positively benefited most carriers who have moved to O&D-based systems.

However, due to structural constraints, including seasonality and system recovery, these major carriers may be close to their load factor limit.

Load Factor Increase

RPK/ASK (%)RPK/ASK (%)

82%

85%CAGR

(%)

+0.6%

79%

78%

80% +1.0%

+0.6%

70%

75%

65%

70%

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Source: Company public information, Seabury analysis.

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

New commercial strategies focus on delivering high service and continued product innovation, targeting quality sensitive customers, particularly corporate and frequent flyers.

Improved products leverage new technologies and social mediums such as AF-KLM’s “Air France KLM Connect”, which enables the airline to inform passengers of any gate changes, delays or disruptions, thus pre-empting customer needs.

Broader frequent flyer programs have remained lucrative with LH Miles & More and AF-KLM Flying Blue recording their 20 millionth customers in February 2011 and early 2012 respectively .

Quality investments enable carriers to compete both in low cost markets, where the target is service-focused customers, and on long-haul segments where the competition, especially in MENA and Asia, offer newer full service products to their

customers. Even during the financial crisis, the Big 3 continued to invest in quality including high-cost cabin upgrades or retrofits. AF-KLM plans €500 million in investment in its Transform 2015 plan while British Airways announced in June 2012 a GBP 5 billion investment plan including fleet and cabin upgrades and on-board product innovations.

Air France-KLM is trying to differentiate its product and is investing 550-million euros in cabin upgrades for its 777 fleet with a business flat-bed seat and a “quick-change” set-up in economy class to match demand needs. British Airways is renewing some of its long-haul fleet, with the purchase of 12 A380 and 24 787, of which the first entry into service is planned for 2013. It includes also the refitting of the long-haul 767 fleet and 18 777-200 with more comfortable seating and upgraded IFE, to match new 777-300ER cabins.


Despite their constant efforts, cost management remains critical for the Big 3. Early 2012 they all announced cost reduction programs for 2012-2014.

After the setup of its program Transform 2015, Air France-KLM presented a loss of EUR895 million in the second quarter of 2012. In terms of costs, it will include a large restructuring program focusing on raising labour productivity, reducing employment and limiting cash expenses.

Lufthansa’ program includes plans for synergies amongst the group carriers, organisational changes, standalone cost reduction goals and revenue improvement initiatives, aiming at a total profit improvement of about 1.5 billion euros by the end of 2014 . After a difficult first quarter, Lufthansa announced a 229 million euros net profit for the second quarter of 2012 and a total loss of 168 million euros for the first half of the year.

With its new subsidiary Iberia Express, Iberia plans to hire pilots from mainline operations and new pilots at market rates . The subsidiary will mostly offer a point-to-point network and feed some long-haul mainline routes. British Airways’ acquisition of bmi will be accompanied with a cut of 1,200 of the 2,700 employees, the resale of the bmi regional, and the grounding of bmi baby. For this second quarter of 2012, IAG recorded a 42 million euros operating loss including bmi purchase and exceptional items. The Big 3 carriers aim at reaching profitability overall and particularly on short-haul markets. Iberia suffered a €263 million operating loss for the first six month of 2012

Focus on Product

Cost Management

5

6

7


Fig 19 - Selected airline credit analysis

Financial ratios indicate risks of liquidity aspects.

Despite a strong recovery in 2010 for the three groups after 2008-2009 crisis, 2011 has been a

difficult year for the Big 3 carriers and in particular for Air France-KLM and Iberia.

Unrestricted Cash / LTM RevenueUnrestrictive cash & equivalent / operating revenue (%)

40.4%45%

2006

20.5%19.0%22.6%22.9%

32.4%

18.0%19.9%

16.4%

28.8%

23.1%25.4%

28.0%24.7%

30.0%

19.0%16.0%

27.0%

15%

20%

25%

30%

35%

40%

2011

2010

2009

2008

2007

2006

LTM EBITDAR Margin

5%

10%

15% Structural minimum

LHGAFKLMIAG

LTM EBITDAR MarginEBIDTAR/Operating results (%)

15.7%15.3%14.5%

18.9%

14.4%16%

18%

20%2006

2007

10.7%

12.5%11.0%

8.6%7.9% 8.1%

3.6%4.8%

10.5%12.2%

11.0%

9.0%

12.0%

4%

6%

8%

10%

12%

14%

2011

2010

2009

2008

Note: LTM EBIDTAR Margin is calculated for the airline groups (including cargo, and other revenues)Source: Public company data

2%

LHGAFKLMIAG

The key indicator in terms of cost is the unit cost performance and its main drivers.

Of the three major operating costs for an airline, fuel and fleet remain largely outside immediate influence, leaving labour as the greatest lever for cost reduction.

Recent efforts to reduce labour cost and realize synergies from consolidation have enabled the Big 3 to reduce CASK ex-fuel, with a 1-5% drop for the Big 3 carriers.

Improvements have been reached in terms of resource utilization as well as optimization of commercial and operational processes.

Fig 20 - Unit cost development

CASK, Ex-fuel CASK (€ cents)CAGR (%)

12

14CASK CASK

ex-fuel

-2% -5%

CAGR (%)

8

10 +1% -3%

+2% -1%

4

6

0

2

2006 2007 2008 2009 2010 2011

CASKCASK Ex-fuel

Note: LH includes LH and Austrian only.Source: Financial public data, Seabury analysis.

2006 2007 2008 2009 2010 2011

Historically IAG and AF-KLM have seen their labour CASK increase by up to 1% per year over 6 years, while LH has been able to optimize its labour to reduce its costs by 8%.

To combat rising labour costs Lufthansa’s SCORE program targets a reduction of 3,500 administrative jobs worldwide over the next three years, plus 2,500 administrative in Germany, giving a 21% reduction in total headcount.

Similarly Austrian Airlines has reduced his labour force of 341 employees .

In its Transform 2015 plan, Air France includes a reduction of 5,122 jobs, i.e. 10% of the total headcount, by the end of 2013. Half of it will be voluntary departures and non-replacement, and will concern at almost 60% ground staff.

The restructuring program also proposes to freeze salaries for Air France and limited salary increases for KLM over 2012-2013. Pilots are incentivised to shift to Transavia, with a 5-6 month salary bonus to compensate the salary cut and the productivity increase .


Fig 21 - Labor unit cost development

Europe has a more regimented labour market than North America and historically it has been difficult to implement labour restructuring, although the North American carriers have needed the negotiating platform provided by Chapter 11 for major labour restructurings as well. Recent changes in legislation, particularly in Spain, however, are looking to give companies greater control on their labour cost management.

The launch of Iberia Express occurred after long months of negotiations during which Iberia was unable to reach an agreement with pilots, unlike their settlement with ground staff and cabin crews, to reduce costs and increase productivity. Not surprisingly, this new subsidiary created more

separation between Iberia and the pilot union SEPLA.

A government appointed arbitrator ruled in May 2012 that Iberia Express is legal and but “have to include all pilots in the same overall pay scale even if working conditions in the two parts of the company were different. IAG has decided to start an appeal process” .

The new labour rules of Iberia Express will also include a reduction of automatic pay hikes, increase in productivity and the drop of some privileges such as seniority-linked extra vacation days in order to reach competitive flight crew costs in the short-haul market.

Labour

Labour CASK (€ cents)

4.0

4.5

5.0

CAGR

2.5

3.0

3.5CAGR

(%)

+1%

-8%

1.0

1.5

2.0 +1%

0.0

0.5

2006 2007 2008 2009 2010 2011

Note: LH includes LH only.Source: Financial public data, Seabury analysis.

8

9

10


Fig 22 - Fuel unit cost development

Despite important efforts to reduce consumption, all carriers across the world have faced increased fuel prices over the last 10 years.

Fuel prices have risen up to more than 30% over the last 5 years for Air France KLM and IAG, whereas Lufthansa Group has managed to limit unit cost rises to 6%, facing a 50% jet fuel increase.

Fuel

Fuel unit cost developmentCASK (€ cents)3 LH Group

AF-CASK -KLMIAG

2 +27%

LH Group

12006 2007 2008 2009 2010 2011

Historical fuel price developmentJet fuel price (€/gallon) 3

1

2

3

+48%

0

1

jan. 08jan. 07jan. 06 juil. 10jan. 09 juil. 09 jan. 10juil. 08 jan. 11juil. 07juil. 06 juil. 11

Note: LH includes LH only; EU annual avg. inflation rate.Source: Financial public data, Index Mundi, Seabury analysis.

A successful optimization of fleet, covering aircraft productivity, age and planned renewal campaigns, can help control costs.

Despite an increase until 2007, aircraft utilization of carriers remains low for narrowbody, 30% less than LCCs and 40% less than Gulf carriers that use these aircraft on longer average stage lengths.

Initiatives such as the new “provincial bases” strategy of Air France to increase the narrowbody fleet productivity can help to increase aircraft utilization.

Widebody average utilisation has also risen until 2008-2009. Lufthansa and Air France have competitive widebody average utilisation compared to Gulf carriers; IAG remains about 20% below benchmark.

Fleet

Fig 23 - 2003-11 aircraft utilisation


Overall the Big 3 European carriers have increased their widebody productivity by 10% over 10 years, while also renewing their fleet.

Currently the Big 3 European carriers and their subsidiaries have a fleet with a profile similar to that of the AACO carriers. Turkish and in average Asian carriers have slightly younger fleets.

Fig 24 - 2011 fleet average age by region

Avg. daily hoursNarrow bodies Wide bodies

10.0

10.5

11.0Etihad

Qatar13.0

13.5

14.0

EtihadEKLH

Narrow bodies Wide bodies

8.5

9.0

9.5Qatar

RyanairEasyjet

LH group 11.5

12.0

12.5Qatar

AF-KLM

7.0

7.5

8.0IAGAF-KLM

g p

10.0

10.5

11.0 IAG

6.0

6.5

201220102008200620049.0

9.5

2002 2004 2006 2008 2010 2012

Note: Based on total annual hours and average fleet size during the year.Source: Ascend, Seabury analysis.

Weighted avg ageWeighted avg. age20

20

16

20

9 1011 11

12

1515

10 10 10 1011

1415

1615

8 89 10

5

10 910

5

10

0 0Narrow bodies

AACO North AfricaBig 3AACO Arabian Gulf AACO Levant

Asia North AmericaECAA AfricaTurkey

Wide bodies

Note: Avg. age weighted by fleet sizeSource: Ascend


Fig 25 - Growth in seat capacity through 2017

Recent consolidations provide opportunities for the Big 3 to realise both revenue and cost synergies.

The success of consolidation has varied but has broadly represented 1-3% of their total operating costs. The synergy targets fall short of the targets of North American airline mergers, which imply billions of dollars of synergies and a full integration in terms of branding, ticketing, airport service, frequent-flier programs and air service when the full operational

merger is reached with a single operating certificate delivered by the authority.

The two airlines, when merging, agree on a revenue management and pricing system, network optimisation and generally large labour cuts to avoid redundancies. Less than 2 years after merger, United-Continental is fully integrated, operates under a single AOC and retains only the name of United Airlines.

However, the Big 3 have limited order backlogs.

Whereas the Big 3 are on average, not far from main competitors in terms of narrowbody orders, they are trailing in the widebody market.

If the markets continue to grow as they have, the Big 3 European carriers will be increasingly unable to provide the resources needed to meet capacity demand. As the fleet age discrepancy increases older fleets will have a direct impact on fuel cost.

% growth versus 2011

N b di Wid b di

160%

180%Big 3LCCs

160%

164%158%

180%Narrow bodies Wide bodies

100%

120%

140% 132%140%

120%

100%

60%

80% 80%

60%

0%

25%14%10%

3%

2%

20%

40%

0%

18%17%4%

40%

20%

Note: Excludes potential impact of utilization changes or parked aircraft returning to service; Assumes Lufthansa Group aircraft currently 20+ years old or Middle East aircraft currently

-2%

13+ years old will by retired by YE2017 AF/KLM includes: Air France, KLM, Cityhopper, Brit Air, Regional; LH Group includes: Lufthansa, Swiss, BMI, BMI regional, Bmibaby, Brussels, Austrian, Tyrolean, Cityline, Eurowings, Germanwings, Air Dolomiti, Augsburg, Contact air; IAG includes: British Airways, Iberia, Air Nostrum, Vueling; U2 includes: Easyjet, EasyjetSwitzerlandSource: Ascend

Synergies


Fig 26 - Selected US and European M&A synergy targets

European mergers have not reached this level of integration with only 600 million euros synergies for Air France-KLM after 8 years.

In cross-border mergers, European airlines tend to enter into assurance agreements that maintain the operating identity and most of the management staff of both carriers, whereas North American airlines tend to significantly reduce combined management staff in the course of the integration process.

The European approach nevertheless allows a certain level of integration. Synergies are limited to economies of scale and some redundant route cuts. This leads to sub optimization vis-à-vis what the North American carriers are able to achieve and reduced revenue production versus what could be obtained by fully-achieved merger managing revenue across a larger network for a single revenue management system.

Air France and KLM still operate under two AOCs, with two independent top managements and distinct back office departments such as pricing and RM.

The 10 to 20% labour cuts currently planned in the Transform 2015 program are a sign that further synergies can be reached, and optimization in the backoffice can still be achieved.

Lufthansa acquisitions have not led to significant integration, its fully owned subsidiaries, SWISS, Austrian Airlines, Germanwings, are run independently.

British Airways is fully integrating bmi into British Airways, which will lead to the cut of all redundancies, transfer of all bmi flights for British Airways service and the strategic redeployment at medium-term of the Heathrow slots, most valuable assets of the new acquired loss-making subsidiary. By the end of 2015 the ‘bmi brand’ is expected to have disappeared.

For all three airline groups, further synergies are possible but politically difficult to achieve.

Selected US merger synergy targetsUSD M

Selected European acquisition synergy targetsUSD M

2,0002,000 Cost synergies 2 000

1,500

2,000

Revenue synergiesCost synergies

1,500

2,000

2001,000

1,0001,000

250500800

600 580

220

500 450

0

(2010)(2008)(2005)

350

0

BA - IB(2009)

230

LH - LX(2005)

156

8670

AF - KL(2004)

S i

Source: Company public reports, Seabury analysis.

Synergies as % of total operating cost

6.0% 6.8% 3.5-4.2% 3.3% 1.2% 3.3%


A flurry of regulations has added further problems to the Big 3 European carriers. The European Commission has actively been working towards deregulating certain aspects of the European market to enhance competition while increasing regulations and other aspects with the impact of increasing costs on all European operating airlines.

The creation of an internal market in the 1990s has enabled removal of restrictions from a formerly highly regulated industry. Limitations on routes, frequencies, fare, have fully disappeared within the EU. Previously traffic rights were agreed between country pairs and were mostly advantaging the national flag carriers and their hubs. This deregulation has directly impacted the Big 3 carriers, which were dominating the EU market.

The last 10 years have also seen a growth in ‘open skies’ agreements across the world. Key agreements have been signed with Morocco, Jordan, the USA and Canada. Others are in discussion such as with Tunisia, Croatia, etc. Similarly as for the EU internal market, these agreements create a flow of new competition for the Big 3 European carriers. As much as the Big 3 European carriers can profit from the restriction removal of entry points and frequencies, all competitors, are now fully allowed to enter the market.

Europe has put in place a full set of regulations to protect customers. International conventions such as the Warsaw and Montreal conventions have set up rules in terms of delayed or missing luggage. The European Parliament completed these with EU legislation on compensation and assistance to passengers in the event of long delays, cancellations or denied boarding and overbooking or bumping. The rules are applicable in the EU and in non-European airports as long as the flight is operated by a European airline .

The regulation also protects against aviation bankruptcy in general. The European market has seen more than 30 bankruptcies since 2005 such as Zoom, Silverjet, Air Madrid, etc. Regulations provide a framework to monitor the general fitness of airlines, insurance and insolvency procedures. An

EC regulation “Package Travel Directive” is in place to provide financial protection to travellers in case of insolvency of package organisers and retailers .

Moreover the EU commission tends to block any merger or acquisition that would create a (quasi-)monopolistic situation which could lead to higher fares. This was the case for the proposed merger of Aegean Airlines and Olympic Air, which together represent more than 90% of the market . Similarly the EU commission prohibited the Air Lingus – Ryanair merger. This would have created “overlaps on more than 30 routes to/from Ireland with very high market shares” and the control of more than 80% of the traffic to/from Dublin airport, which is a potential risk for high fare increase . Two current recent cases need to be mentioned: the finally approved acquisition of bmi by British Airways and the still pending UPS-TNT Airways merger. For the first case, the agreement has been achieved after 5 key concessions made by British Airways including:

- The surrender of 14 slots at Heathrow airport to avoid monopolistic or duopolistic configurations on specific routes;- The possibility to sell British Airways fares to any carrier increasing capacity on one of the routes above to increase schedule proposition to the customer;- Special prorate agreements for key routes on short-haul markets to allow other carriers to access favourable rates on IAG services;- The access to IAG frequent Flyer Program if a carrier on these routes does not have any;- The termination of IAG’s codeshare with Royal Jordanian on the route Heathrow-Amman if BA maintaining this route.

In the second acquisition case, TNT Airways aims at purchasing the Amsterdam based package shipper UPS for 5.16 billion euros. A first high-level study from the EU commission highlighted some potential competition concerns. A second review has been launched, which could last until November 25th. The regulatory clearance will be granted only if customer access to service at competitive prices is not altered. All these cases highlight the crucial role of the EU commission in the aviation consolidation process in the European market.

Regulatory Environment

11

12

13

14


Regarding environmental protection, the European Trade Scheme (ETS) has raised controversy across the global industry. The scheme, in which airlines have been required to participate in since January 2012, is a cap-and-trade system for all emissions of greenhouse gases in the EU zone, aimed at reducing emissions in all EU industries. However, the scheme applies to the full journey of all flights that touch ground in the EU, irrespective of where the emissions actually occur. Certain countries, such as China and India, have announced that their airlines would not participate to this scheme, while a group of unwilling countries are working on retaliatory measures.

While the carriers have to compete on a pan-European basis, individual European governments add national financial constraints. Within Europe, certain countries have decided on an individual basis to add entry/exit passenger taxes. The UK

government levies the ADP (Air Passenger Duty) for all departing passengers, which increased from GBP 5 in 2006 to GBP 13 for short-haul and up to GBP 184 for long-haul depending on the destination. Similar taxes have been introduced in the Netherlands but then in 2008 withdrawn a year and a half later, are still in place in Ireland but limited at only EUR 3 per passenger, and have been in effect in Germany since January 2011 at between EUR 8 and 42. These taxes have a negative impact on passenger volumes, especially with price-sensitive customers less likely to travel at a higher fare. A policy of harmonization or removal of these taxes to avoid any non-competitive advantage within the EU is not likely to surface.

The big three European carriers have been focusing their growth in the markets where their relatively higher cost structures don’t matter nearly as much, because fuel is a large portion of the direct costs. These long-haul/wide-body markets tend to overfly most of the Arab world, but their success depends almost entirely on the premium passenger markets. The areas most at risk of direct competition from these carriers include the far ends of Arabia and the flows into the Indian subcontinent, sub-Saharan, and Southeast Asia from Europe. With the exception of Africa, the Arab carriers in the Arabian Gulf are competing favourably in these markets, as their products tend to be better, and their cost structure tends to be lower than the European carriers. However all of the Arab air carriers have a unique ability to attract traffic from the larger

European markets and connect the near regions well. A handful of Arab air carriers have recognized this opportunity. However capitalizing on it entails its own set of challenges. The Arab carriers need to be able to sell into the home markets of the European carriers effectively and with limited brand space of mind. This requires top quality salesmanship and management of distribution channels as well as effective Internet sales platforms, which most of the Arab carriers need to improve.

Finally, the cost pressure from the European low-cost competitors eventually will impact the Arab air carriers as it already has impacted the European big three carriers. Achieving and maintaining cost competitiveness on narrowbody flying should be a focal point for many of the Arab carriers.

Closing Thoughts

Source: Air Travel Advisory Bureau, Know your rights (2012)11

Source: www.europarl.europa.eu, All-inclusive air fares just around the corner as MEP back legislation on transparency, 9 July 200812

Source: Europa.eu, Mergers: Commission blocks proposed merger between Aegean Airlines and Olympic Air, 26 January 201113

Source: Europa.eu, Yes, we can (prohibit) –The Ryanair/Aer Lingus merger before the Court, 9 March 201014

Source: European monitoring centre on change 8

Source: CAPA, Air France-KLM sinks deeper into the red as it further revises capex and capacity, 31 July 20129

Source: FT.com, Iberia to challenge key pilots’ ruling, 21 June 201210

Source: company websites 5

Source: CAPA, Lufthansa 1Q2012 operating loss widens as crown-jewel subsidiary SWISS sinks into the red, 4 May 20126

Source: CAPA, Iberia Express launches as Europe’s latest salvo to bring short-haul model to profitability, 27th March 20127

Source: Air France-KLM, Registration document 2011, April 2012 2

Source: Les Echos, Les principales mesures du plan Transform 20153

Source: BloombergBusinessWeek, Lufthansa freezes capacity plane orders in savings drive, 23 April 20124

Source: Ryanair website; easyJet 2011 annual report; easyJet 2013Q2 results1

RPK Growth Q4’11 (% YOY)RPK Growth Q4 11 (% YOY)

20

30 1 billion ASKs

EY

QRSV

0

10

PLF (%)

WYTU

ME GFG9

EK

QR

RJ

-20

-1060 62 64 66 68 70 72 74 76 78 80 82

KU

-30

MS


StatisticsExecutive Summary Statistics Source: AACO

Note: Includes scheduled operations for EK, EY, G9, GF, KU, ME, MS, QR, RJ, SV, TU, WY

AACO members passenger size and growth Fig 1 - Year-on-year revenue passenger kilometers (RPKs) growth versus passenger load factor (PLF).Bubble size indicates carrier size measured as available seat kilometers ( ASKs)Source: AACO

Total Q4 Year-on-Year Change International Q4 Year-on-

Year Change Domestic Q4 Year-on-Year Change

No. of Pax 27,339,798 6.8% 23,741,103 7.3% 3,598,695 4.2%

Tonnes Cgo 867,858 5.0% 853,124 5.3% 14,734 -9.7%g

RPKs (000) 92,424,222 8.9% 89,607,052 8.9% 2,817,169 10.7%

ASKs (000) 123 767 527 10 2% 120 003 204 10 2% 3 764 322 8 8%ASKs (000) 123,767,527 10.2% 120,003,204 10.2% 3,764,322 8.8%

Pax Load Factor 74.68% -0.86 pp 74.67% -0.93 pp 74.84% 1.22 pp

RTKs (000) 11,316,044 6.5% 11,045,582 6.3% 270,462 8.1%

ATKs (000) 19,017,286 11.6% 18,522,769 11.3% 494,516 8.3%

Weight Load Factor 59.50% -2.83 pp 59.63% -2.76 pp 54.69% -0.07 pp

Pax (million)Pax (million)

54.155.0-1.5%

60

5052.2

47.7

40

30

gers

20

Pas

seng

10

Q4-2011Q4-2010Q4-2009Q4-20080


AACO members cargo size and growth Fig 2 - Year-on-year revenue tonne kilometers (RTKs) growth versus weight load factor (WLF). Bubble size indicates carrier size measured as available tonnes kilometers (ATKs)Source AACO

Arab passenger growth Fig 3 - Historical trend of fourth quarter passenger numbers at most Arab airportsSource: AACO, ACI

Arab cargo growth Fig 4 - Historical trend of fourth quarter cargo transported at most Arab airportsSource: AACO, ACI

RTK Growth Q4’11 (% YOY)

20

40

SV

500 million ATKs

RTK Growth Q4 11 (% YOY)

0

20

TU

SV

RJQR

ME

KU

GF EKWY

-20

45 50 55 60 65 70 75

WLF (%)

MS

KU

-40

Tonnes (thousand)+2.6%

Tonnes (thousand)1,500

1,4941,4571,379

1,197

1,000

o

500 Car

go

0Q4-2011Q4-2010Q4-2009Q4-2008


Arab departure growth Fig 5 - Historical trend of fourth quarter aircraft traffic volume in most Arab airportsSource: AACO, ACI

Intra-regional Arab market Fig 6 – Fourth quarter international Arab market passenger numbers within the Arab WorldSource: AACO, IATA

Inter-regional Arab market Fig 7 - Fourth quarter Arab market passenger numbers to/from the Arab worldSource: AACO, IATA

Departures (thousand) 17 4%Departures (thousand) -17.4%

478

579565

494

600

500

300 ures

400

200

100

Dep

artu

0Q4-2010 Q4-2011Q4-2009Q4-2008

Pax (thousand)

3,500

3,000-1%

+24%Q4-2009

Q4 2011Q4-2010

2,500

2,000

Q4-2011

-48%-24%+3%+2%

1,500

1,000

500

WithinNorth Africa

WithinNear East

Near East- North Africa

North Africa - Arabian

WithinArabian

0

-48%500

Near East - Arabian North AfricaNear East North AfricaArabian

PeninsulaArabian

PeninsulaArabian

Peninsula

Pax (thousand)

12,000

10,000

+2%Q4-2010Q4 2011

Q4-2009

8,000

6,000

+6% Q4-2011

4,000

2,000 -3%+4%

-4%

,

0With the AmericasWith Sub-

Saharan AfricaWith AustralasiaWith Mid AsiaWith Europe

Saharan Africa


Airport passenger volume Fig 8 – 2011 fourth quarter passenger volume in most Arab airports by portSource: AACO, ACI

Airport cargo volume Fig 9 – 2011 fourth quarter cargo volume in most Arab airports by portSource: AACO, ACI

DXB

2,500

Pax (thousand)

3,000 5,0004,5004,0003,500 13,5002,0001,5001,0005000

DXB

AUHRUHJED

DOH

KWICAI

MCTSSHCMNHRGBAHKWI

TUNALG

AMMBEY

DMMSHJ

RAK

LXRAGA

RKTMIR

ALX

ASWRBAALX

FJR

16012080400

DXB

Tonnes (thousand)

600200

AUHDOH

JEDBAHCAISHJ

DXB

MCTKWIRUHJED

AMMBEY

RAK

DMM

ALGTUNFJR

CMN

HRGMIRAGA

RBA

LXRRKT

ASWALXSSHHRG


Domestic and international Fig 10 - Fourth quarter AACO members’ domestic/regional and international passenger volume historical trendNote: Includes scheduled operations for EK, EY, G9, GF, KU, ME, MS, QR, RJ, SV, TU, WYSource: AACO

Fleet growth Fig 11 - AACO members combined fleet growth by aircraft typeSource: AACO, ASCEND

Fleet changes this quarter Fig 12 – Forth quarter changes to the AACO fleet by carrierSource: AACO, ASCEND

Pax (million)Pax (million)30

25 22.7

27.3

3.625.6

3.5Dom.Passengers

20

15

3.219.62.7

10

5

19.516.8

23.722.1Int’lPassengers

0Q4-2009Q4-2008 Q4-2011Q4-2010

AircraftAircraft

800

1,000

RegionalFreighter

908

9%5%862

9%4%767

%

600

41%

7%5%

Narrow Body41%

9%

42%

8%4%675

41%

200

40041%

Wide Body45%45%46%48%

02011201020092008

48%

Avg Seats 217.1 214.8 213.2 215.0

Avg Age (Yr) 9.12 7.70 7.31 7.37

Aircraft IASD

Aircraft

908893900

950

MSAT TUQR

44LN8U

G9

IARJ29

R5Rotana Jet*SV

850

EY

IAR5

ATGFG9

750

800

EKBJ*

SVMSEY

700Q4-2011Parked/RetiredQ3-2011 Additions

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Documents

3D Insight - AACO Insight... · Secondly, while LCCs have driven Intra-European capacity growth at an annual average growth rate of 21% per annum over the last 10 years, the Big 3