Valuation of

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Valuation of

and the Changing Market Environment Following the Insolvency of Airberlin

Program: MSc Applied Economics and Finance

Authors: Karen Patricia Steffe (Student number: 106981) Maria Frederiksen (Student number: 57417) Supervisor: Bo Danø

Date of submission: 15th of May, 2018

Master Thesis

Copenhagen Business School 2018

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32228 32176

35091 33939

37961

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2013 2014 2015 2016 2017 Executive Summary

Objective

§ The objective of this master thesis is to evaluate the share price of Lufthansa Group within its current market position and to give an outlook on industry changes following the insolvency of airberlin.

Lufthansa at a Glance

§ Founded in 1926,

Lufthansa Group is based in Germany and is currently the largest airline group in Europe

§ Lufthansa operates three business segments:

1) Network Airlines 2) Point-to-Point Airlines 3) Aviation Services

§ As of December 31^st, 2017, Lufthansa had 471,259,644 shares out- standing, trading at a share price of EUR 30.72

Problem Statement

§ What is a fair share price for Lufthansa as of December 31^st, 2017 and how will the insolvency of airberlin change the

This master thesis is a valuation of Lufthansa Group as of December 31^st, 2017 in light of the changing market environment driven by the insolvency of airberlin Group.

The airline industry is at constant change

Some structural challenges increasingly define the business environment for Lufthansa with large implications on the corporate agenda. Since the liberalization of the EU flight market, competition significantly increased. The entry of Low Cost Carriers as well as ongoing consolidation in the sector puts high pressure on ticket prices, while costs are driven by fuel expenses as well as employees’ salaries and wages.

Insolvency of airberlin strengthens Lufthansa’s market position Through the insolvency of airberlin, Lufthansa’s market share on intra-German flights increased from 69% to 87%, making it the dominant player in this country. It also helped Lufthansa to report a record high net income in 2017 and made the share price increase by almost 150% during that year.

"Nobody has yet endangered Lufthansa, but surely many have challenged us.” Carsten Spohr, CEO Lufthansa Group

30%

15%

+4.2% p.a.

Lufthansa revenue,EUR million Share price development 2017 Highlights

Conclusion

§ By employing both valuation methodologies and other analysts predictions, a suggested value range of EUR 18.49 – 39.50is obtained

DCF

Multiple

Other Analysts

Executive Summary

Aviation Market Europe

§ In 2017, there were 146 aviation companies active in the European market

16%

10% 13%

9%

36%

Market shares based on available passenger seats

01 / 2017 12 / 2017

Others

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1 Introduction

1.1 Background

The airline industry worldwide is in constant change, with old players leaving the market and new entrants emerging every year. Especially since the liberalization of the EU flight market in 1987, competition significantly increased, with many Low Cost Carriers (LCCs) entering the market, putting pressure on ticket prices. Across the US and Europe, also airline consolidation continues to effect the competitive landscape for carriers.

“Greater commercial freedom for airlines is vital for the long-term health of the industry and for the global economy” (Smyth & Pearce, 2007, p. 3).

In light of this background, Lufthansa German Airline evolved to become Germany’s flag carrier (former government owned airlines) since its foundation in 1926. Together with its subsidiaries, it is nowadays not only the largest airline in Germany, but in 2017 also became the largest airline by passengers in Europe (O'Shea, 2018). While other European airlines like Alitalia and airberlin went bankrupt in 2017, Lufthansa Group reported record annual earnings for the third year in a row (Reuters, 2018) and its share price stood at an all-time high of EUR 31.12 on December 28th, 2017 (Yahoo Finance, 2018). What makes Lufthansa so strong compared to other airlines and is this share price a fair valuation of the company? Will the bankruptcy of airberlin further strengthen the company’s market position and what are the effects of a takeover of (parts of) airberlin?

1.2 Purpose and Problem Statement

The purpose of this master thesis is therefore to evaluate Lufthansa Group within its current market situation and to give an outlook on industry changes following the acquisition of airberlin.

To determine the fair value and share price of Lufthansa Group, an independent strategic assessment will be conducted, including the identification of underlying strategic advantages and financial drivers of the airline market. The financial valuation of Lufthansa is based on different valuation methodologies. Lastly, the acquisition deal of airberlin will be examined from a regulatory position as well as a market view.

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As a guidance for the analyses and design of this master thesis, the following problem statement has been articulated:

What is a fair share price for Lufthansa as of December 31st, 2017 and how will the insolvency of airberlin change the company’s position in the market?

1.3 Structure of the Paper

In order to provide answers to the above stated research question, this thesis is prepared according to the following structure.

Initially, some background is given on Lufthansa Group, before starting the strategic analysis, which covers an assessment of the market and both the external and internal factors relevant for the valuation of Lufthansa. This includes a comprehensive analysis regarding Lufthansa’s competitive position.

Subsequently, in order to establish the foundation for the financial valuation of Lufthansa, a financial ratio analysis will be provided based on reclassified financial statements of Lufthansa and its peers.

This part is then followed by the financial valuation of Lufthansa, which is conducted via a discounted cash flow model and the multiple methodology, and further validated by a sensitivity analysis.

The last part focuses on Lufthansa’s acquisition of airberlin. After presenting some background information on the deal, the EU Commission’s concerns will be illustrated and an overview of market reactions will be given.

This master thesis will therefore provide a holistic view on Lufthansa’s fair share price and position in the market.

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2 Methodology

2.1 Research Design

The main contribution of the thesis is the valuation of Lufthansa Group in the context of a changing market situation.

The thesis will consist of two main parts, a strategic and financial valuation of Lufthansa Group as well as implications derived from the acquisition of (parts of) airberlin Group. The strategic subsection will focus on overall market developments as well as firm-specific characteristics and will give answers to the following questions:

Strategic sub-questions

- How did Lufthansa evolve historically and how does it influence its performance nowadays?

- Which macroeconomic factors affect Lufthansa’s operating markets?

- What are Lufthansa’s core competencies, its value proposition, and overall strategic position?

- How is the competitive environment in Lufthansa’s core markets and how can the company exploit this situation?

Secondly, the financial valuation will use the DuPont model to analyze Lufthansa’s financial performance in the past and will then conduct a valuation of Lufthansa by applying a discounted cash flow model. This second part will therefore answer the questions presented below:

Financial sub-questions

- How did Lufthansa’s performance evolve over the past years and how does that compare to its main competitors?

- What are the financial value drivers behind Lufthansa’s historical performance?

- What is the expectation about Lufthansa’s future performance?

- What is a theoretically fair price of Lufthansa shares as of December 31^st, 2017?

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The last part will then examine the takeover of airberlin assets and will give opinions on the following questions:

Airberlin sub-questions

- What are the reasons for the insolvency of airberlin and are those possible threats for Lufthansa’s business as well?

- What are the regulator’s concerns regarding this deal?

- How did the acquisition of (parts of) airberlin impact the market and Lufthansa’s market position?

- What impact did the deal have on Lufthansa’s share price?

2.2 Theory

Throughout the strategic and financial valuation, several theoretical models have been applied, including PESTEL and Porter’s Five Forces analyses, a SWOT analysis, the DuPont model, and a DCF and multiple valuation. The relevant theoretical elaboration and considerations of the various methodologies are included in the respective sections.

Additionally, this master thesis includes a perspective on the changes in industry following the airberlin transaction.

2.3 Data Collection

Lufthansa is evaluated from an outside-in perspective, meaning that only publicly available information is used. Main sources include Lufthansa’s and its competitors’ annual reports, as well as market and industry reports. Furthermore, theoretical frameworks are used in accordance with books from Peters & Plenborg, Damodaran, Berk & DeMarzo, and others.

2.4 Data Limitation and Criticism

The valuation of Lufthansa is conducted as of December 31st, 2017. Their annual report 2017 was released on March 15th, 2018 (Lufthansa, 2018), which will be seen as a cut-off date. This means that the strategic and financial valuation will not include information that was made public after this date, except for the Annual Report 2017 of Air France-KLM, which is included for better comparability between the firms, even though it was published after the cut-off date.

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Additionally, to ensure that all information regarding the airberlin transaction is up-to-date, all data publicized before May 15th, 2018 is included in the second part of the thesis.

The thesis addresses all current and potential private and institutional investors, from which it is assumed that they possess basic knowledge of business strategy, statistics, and corporate finance. The thesis therefore only contains limited explanations of the applied theories and methodologies.

One of the main challenges is making reliable forecasts of the development of Lufthansa’s business. A fundamental aspect of this thesis is thus the relevance of reasonable and well- founded assumptions, which will be clearly stated and outlined throughout the respective sections. However, the financial valuation should still be regarded with precaution.

Furthermore, Lufthansa Group operates in various subsectors of the aviation industry, e.g.

passenger aviation, cargo, maintenance and repair services, and catering. However, as the largest part of its business is conducted within the passenger airlines, the main focus will be on this market, especially within the strategic analyses.

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3 Strategic Analysis

3.1 Company Introduction – Lufthansa Group

“Keeping up tradition means reflecting on where you come from and, from this reflection and experience, defining where you're going.“

(Abraham - Co-Founder of the Deutsche Lufthansa Berlin-Stiftung, p. 1) 3.1.1 Lufthansa in Brief

Deutsche Lufthansa AG (commonly referred to as Lufthansa or Lufthansa Group) is the largest airline in Germany and the third largest airline worldwide based on revenue in FY17 (Euromonitor, 2017). The airline carried 130 million passengers on 1,130,008 flights in 2017 and held a fleet of 728 aircrafts with an average age of 11.4 years as of December 31st, 2017 (Lufthansa Annual Report, 2017). This growth of 111 aircrafts compared to 2016 is due to the wet-lease contract of aircrafts from airberlin Group and the consolidation of Brussels Airlines.

Furthermore, the company served a route network of 301 destinations in 103 countries in 2017 (Lufthansa Annual Report, 2017) .

The history of Lufthansa can be traced back to January 6th, 1926 when the company was formed from the consolidation of two German aviation interests as “Deutsche Luft Hansa AG”

(Lufthansa, n.d.). At this time, Lufthansa was a monopoly run by the German government (Grant, 2005). During the second world war, Lufthansa was forced by law to provide services, transport flights and technical operations for the German government, until the operations got suspended in 1945 and the company was dissolved in 1951 (Lufthansa, n.d.).

Lufthansa, as it is known today, was founded on January 6th, 1953 as “Aktiengesellschaft für Luftverkehrsbedarf” (Luftag). Since the company bought the trademark, name, and colors from the first Lufthansa in 1954, it called itself “Deutsche Lufthansa Aktiengesellschaft” (Lufthansa, n.d.).

Nowadays, Lufthansa Group is a global aviation group, which consists of 331 subsidiaries as of FY17, structured into the Business Segments Network Airlines, Point-to-Point, and Aviation Services (Lufthansa Annual Report, 2017).

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3.1.2 Lufthansa Group’s Business Segments and Products

Lufthansa’s largest business segment (63.6% as of December 2017) is the Network Airlines business segment, consisting of Lufthansa German Airlines, SWISS, and Austrian Airlines (Lufthansa Annual Report, 2017).

As of January 2017, Eurowings, Brussels Airlines and the equity investment in SunExpress have been removed from the Network Airlines segment and integrated into a separate Point-to- Point Airlines segment, accounting for 11.4% of total revenue as of December 2017 (Lufthansa Annual Report, 2017).

A third business segment, Aviation Services, is composed of several sub-segments, including Maintenance Repair Overhaul (MRO, 10.0%), Catering (7.2%), Logistics (7.0%) and Additional Businesses and Group Functions (0.8%, (Lufthansa Annual Report, 2017)).

The segment Maintenance Repair Overhaul (MRO) is an independent provider of maintenance, repair, and overhaul services for civilian commercial aircraft, and is composed of Lufthansa Technik Group, which itself has 31 maintenance operations worldwide and furthermore holds stakes in 57 companies. Its services, ranging from “the repair of individual components to consultancy services and fully integrated supply of entire fleets” (Lufthansa Annual Report, 2017, p. 3), are offered via seven divisions: Aircraft Overhaul, Aircraft Systems, Components, Engines, Innovations and Completion, Maintenance, and Servicing of VIP Aircraft (Lufthansa, n.d.).

The sub-segment Catering consists of LSG Group, which is composed of several subsidiaries under LSG Lufthansa Service Holding AG. LSG Group established LSG Sky Chefs, which operates airport lounges and offers in-flight products and services (food, equipment, onboard retail, and logistics) through a network of 205 facilities in 50 countries (LSGgroup, n.d.).

Lufthansa Group’s smallest sub-segment Logistics mainly consists of Lufthansa Cargo, one of the world’s largest provider of international scheduled airfreight services, which focuses on airport-to-airport air cargo business. The subsidiary offers its services through 17 own aircrafts, but also makes use of chartered cargo aircrafts and belly capacities on passenger aircrafts operated by Lufthansa, Austrian Airlines, and Eurowings (Lufthansa, n.d.).

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Lufthansa Group therefore operates in the overall aviation market, but as its main operations are in the Passenger Airline segment (Network Airlines and Point-to-Point Airlines), we will concentrate our analyses on this market.

3.1.3 Investors

In 1966, Lufthansa shares were traded for the first time and since then have been traded on several German stock exchanges. As of December 31st, 2017, trading in Germany took place on Frankfurt stock exchange and electronically on XETRA, while in the United States, shares are traded via a sponsored American Depositary Receipt (ADR), with Deutsche Bank Trust Company Americas being the depositary (Lufthansa, n.d.). ADRs are “certificates issued by a US depository bank, representing foreign shares held by the bank, usually by a branch or correspondent in the country of issue. One ADR may represent a portion of a foreign share, one share or a bundle of shares of a foreign corporation. If the ADR's are "sponsored," the corporation provides financial information and other assistance to the bank and may subsidize the administration of the ADR” (NASDAQ, 2017, p. 1). In the case of Lufthansa, one ADR represents one underlying share. The total number of issued shares as of December 31st, 2017 was 471,259,644 (Lufthansa, n.d.), which were traded at a closing price of EUR 30.72 (Lufthansa Annual Report, 2017). Lufthansa shares are widely held by several shareholders, with a free float of 100% according to Deutsche Börse AG. The shareholder structure by nationality reveals that most shareholders are German (72.1%), followed by US nationals (9.6%) and Luxembourg nationals (5.3% (Lufthansa, n.d.)), as shown in Figure 1:

Figure 1 - Shareholder Structure By Nationality 2017, Based on (Lufthansa, n.d.)

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3.1.4 Corporate Governance

For Lufthansa, Corporate Governance “is of vital importance for guaranteeing enhanced transparency towards shareholders and helps developing continuous trust with [their]

management” (Lufthansa, n.d., p. 1). Corporate Governance at Lufthansa is based upon the German Companies Act (Aktiengesetz), the German Codetermination Act (Mitbestimmungsgesetz), the German Corporate Governance Code, and the German Corporate Governance Codex (Deutsche Corporate Governance Kodex DCGK). Lufthansa applies a corporate governance structure as shown in Figure 2 (Lufthansa, n.d.):

Figure 2 - Corporate Governance Structure, Based on (Lufthansa, n.d.)

Lufthansa operates as a German stock corporation (Aktiengesellschaft, AG). For these companies it is typical to have a two-tier board which is separated into the Executive Board and the Supervisory Board. The German Stock Corporation Act prohibits being member in both boards at the same time. Furthermore, it defines the responsibilities of the executive board (or also called board of management) as managing and representing the company against other parties. The supervisory board, on the other hand, is responsible of overseeing the company’s board of management and also has the right and obligation to appoint members to the board of management. It is therefore not directly involved in the daily business operations and should be independent from the management (SGLGroup, n.d.). Lufthansa’s supervisory board is represented by a total of 20 member, ten being shareholder representatives and ten employee

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representatives. All shareholder representatives have gained experience as members of other supervisory boards. Furthermore, 75% of all supervisory board members have been a member for less than 6 years, which is an indicator for high independence at the supervisory board (Lufthansa, 2018). Member’s expertise is guaranteed by a pre-defined nomination process of new candidates, focusing on relevant skills, diversity, and experience. However, members are also being supported by several committees, including the Steering Committee, the Audit Committee, the Arbitration Committee, and the Nomination Committee.

As for the supervisory board, also for the executive board basic criteria exist for the selection of their members, being for example leadership skills, personality, professional qualification, diversity, etc. In 2017, Lufthansa had five members in the executive board, including the CEO Carsten Spohr (Lufthansa, n.d.). The executive board is in charge of the company’s operations and sets the company’s strategy discussed in the next section.

3.1.5 Company Strategy

“Customers are at the heart of the airline group’s market strategy, which is based on the pillars of high quality, safety, punctuality, dependability and professional service. An awareness of ecological responsibilities also features strongly in the airline group’s business activities”

(Lufthansa, p. 1).

The airline’s long-term goal is “to be the first choice in aviation for customers, employees, shareholders and partners” (Lufthansa, n.d., p. 1). To reach this goal, Lufthansa operates as a premium provider in the aviation market, focusing on high-quality travel experience for the customers.

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Three pillars build up Lufthansa’s corporate strategy: Network Airlines, Point-to-Point Airlines, and Aviation Services (Lufthansa, n.d.), as can be seen in the figure below:

Figure 3 - Three Pillars of Lufthansa's Corporate Strategy, Based on (Lufthansa, n.d.)

Lufthansa’s business segments are connected via these three pillars and therefore exploit synergies and economies of scale. Furthermore, Lufthansa consistently reviews and adapts its business model, products and services in order to stay profitable in a digitalized world. The company therefore initiated the program “7to1 – Our Way Forward”, which implements the program’s seven action areas in and across all business segments (Lufthansa, n.d.):

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Figure 4 - "7-to-1 - Our Way Forward" Strategy, Based on (Lufthansa, n.d.)

3.1.6 Alliances and Partner Airlines

Other important aspects of Lufthansa’s strategy are alliances and partner airlines. Lufthansa is a founding member of the world’s biggest global aviation network, Star Alliance, which was established in 1997 in order “to offer customer convenient worldwide reach and a smoother travel experience” (Lufthansa, n.d., p. 1). Furthermore, Lufthansa Regional, a partner of Air Dolomiti and Lufthansa CityLine, offers point-to-point flights across Europe and to onward international destinations.

Lufthansa also cooperates with United Airlines and Air Canada in the A++ transatlantic joint venture, with All Nippon Airways in the J+ bilateral Europe/Japan joint venture and through a commercial joint venture with Singapore Airlines (Lufthansa, n.d.).

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Those strategic alliances not only help airlines to reduce their costs and exploit synergies, but also increase the customer service offered (Lufthansa, n.d.), as will be further evaluated in Section 3.2.

3.2 External Factors – Market Assessment 3.2.1 The Global Flight Market

According to Marketline, “the airlines industry comprises passenger air transportation, including both scheduled and chartered, but excludes air freight transport” (Marketline, 2017, p. 7), and reached a value of almost USD 600 billion in 2016, while the European market has a market size of USD 130 billion. The German market accounts for 3.7% of the total market or USD 22.4 billion and had 110.7 million passengers in 2016 (Marketline, 2017).

Economic growth, varying consumer demand, volatile oil prices, as well as changes in regulations and technologies are continuously shaping and impacting the global flight market.

Average growth of 6.2% per year in demand of passenger air travel worldwide and airfare decreases of 0.9% per year were seen over the past ten years (Boeing, 2017). In 2017, industry- wide Revenue Seat Kilometers (RSKs) grew by 7.6% and are expected to further grow by 7.5%- 8% in 2018 (IATA, 2017). By the end of 2021, Marketline predicts the global industry value to be above USD 900 billion, achieved through a CAGR of 8.9% between 2016 – 2021 (Marketline, 2017). However, the German market is more saturated already, only showed market growth rates (CAGR) of 3.5% between 2012 and 2016 and is forecasted to grow by 4.7% (CAGR) in 2016 – 2021 (Marketline, 2017). The same applies to the European market, which grew by 4.4% between 2012 – 2016 and is expected to have a CAGR of 6.5% in 2016 – 2021 (Marketline, 2017).

Forces shaping this growth include increasing presence of Low Cost Carriers (LCCs), Middle East carriers, consolidation and alliances of airlines as well as dynamics of new startups and ceased airlines. These factors will be discussed in the next sections.

3.2.1.1 Low Cost Carriers

LCC has been a known airline business model since its introduction in the 1970s and has grown to capture large market shares in the aviation industry. As observed in Figure 5, Low Cost Carriers occupy more than 30% of the total number of seats in Europe and 53% in South East Asia.

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Figure 5 - LCC Share of Total Seats by Region, Own Depiction Based on Boeing (2017)

Low Cost Carriers often operate point-to-point flights, usually at secondary airports, have high utilization, quick turnaround, limited services and standardized aircrafts on short-haul flights, leading to high effectiveness with load factors of more than 90% (Boeing, 2017).

These characteristics enable the carriers to offer low airfares. Long-haul flights are arguably more complex as networks of feeders need to be established and regulatory requirements are higher (Boeing, 2017). Nevertheless, attempting to meet consumer demands for low fares on long-haul flights, it is seen that LCC carriers also enter the long-haul market as seen with Norwegian shuttles flying to North America, while network carriers like Lufthansa start utilizing their low cost subsidiaries on the same routes (Boeing, 2017).

3.2.1.2 Startup and Ceased Airlines

Growing demand in the global airline market attracts large numbers of new airline operators, while the competitive environment additionally drives a large number of businesses to terminate.

According to CAPA – Center for Aviation (2017), more than 60 startup carriers were launched between August 2015 to August 2016, of which the majority consisted of full service and charter carriers. Europe experienced the largest share of start-ups (34%, followed by Asia- Pacific (21%) and Latin America (21%), as can be seen in Figure 6.

31%

37%

4%

53%

33%

22%

19%

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31%

13%

0,00 5,00 10,00 15,00 20,00 25,00

Europe North America China Southeast Asia Latin America Northeast Asia Middle East South Asia Oceania Africa

Non-LCC LCC

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Figure 6 - Recently Launched Start-Ups by Region, August 2015 – August 2016, Own Depiction Based on CAPA (2017)

45 airlines were however ceased in the same period, of which the majority of 26 carriers were European, including Cyprus Airways, Estonian Air, and Lithuanian Air (CAPA, 2017). In 2017, the Middle East carrier Etihad pulled funding from a Swiss regional operator and German airline airberlin, after which both carriers terminated their businesses (Dunn, 2017) with easyJet and Lufthansa seeking to acquire assets from airberlin Group.

Figure 7 - Recently Ceased Operations by Region, August 2015 – August 2016, Own Depiction Based on CAPA (2017)

On the other side, businesses started in 2017 include the creation of Joon, a hybrid operation of Air France-KLM flying short haul from Paris and long haul to Brazil from 2018 on (Dunn, 2017), as well as the foundation of easyJet Europe to ensure easyJet’s European operations in light of Brexit.

34%

21% 10%

21%

11%

3%

Recently Launched Start-Ups by Region

Europe North America Asia-Pacific Latin America Africa Middle East

58%

9%

13%

5%

13%

2%

Recently Ceased Operations by Region

Europe North America Asia-Pacific Latin America Africa Middle East

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3.2.1.3 Middle East Carriers

Another trend in the global aviation market, which is particularly relevant for European carriers, is the growing presence of Middle East carriers. Geographical locations of Middle East nations enable their airlines to operate direct flights to destinations such as Asia. Similar to Asian airlines, Middle East carriers have advantages in terms of cost and quality of service.

Additionally, the presence of Middle East airlines and groups is found in their investments in European airlines, as seen with Etihad’s stakes in airberlin and Alitalia as well as Qatar Airways stakes in IAG (Canelas & Ramos, 2016). However, in 2017 the market share of Middle Eastern airlines fell for the first time since 1997 and lies around 9.5% as of December 2017, while the European market still accounts for more than 1/4th of the market (IATA, 2017):

Figure 8 - Market Share by Region in 2017, Own Depiction Based on IATA (2017)

3.2.1.4 Alliances

As a response to competition from LCCs and Middle East carriers, network carriers seek alternative strategies through alliances and consolidation. Alliances allow airlines to serve more destinations, provide higher connectivity and share loyalty programs across allied carriers through code sharing. As seen in Figure 9, the three biggest airline alliances worldwide are Star Alliance, which represented the largest alliance in 2016, followed by SkyTeam and Oneworld, while the majority of the market shares were still held by airlines that are not in alliances.

2%

34%

26%

5%

10%

23%

Market Share 2017

Africa Asia Pacific Europe Latin America Middle East North America

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Figure 9 - Leading Airline Alliances in 2016, by Market Share, Own Depiction Based on Statista.com

Consolidation strategies vary, and reach from mergers of network carrier such as KLM and Air France in 2004 (Milner, 2004) to the establishment or acquisition of low cost subsidiaries such as Lufthansa’s acquisition of Germanwings (Krishnamurthy, 2016).

3.2.2 PESTLE Analysis

In the next part, the impact of macroeconomic factors on Lufthansa and the airline industry will be analyzed using the PESTLE framework. This framework helps identifying the “factors [that]

will change the forces in the industry” (Galavan, 2004) and its results can be used in the assessment of a company’s competitive position. Political, economic, social, technological, legal and environmental factors influencing Lufthansa’s business environment are considered with a focus on the European airline industry.

3.2.2.1 Political

Liberalization of the aviation industry over the past 20 years has increased competition within the European market. Before that, network carriers like Lufthansa, KLM, SAS amongst others, have enjoyed monopolistic positions serving and connecting in their national markets.

However, union policies allowing member states’ airlines to freely operate within other member states as well as initiatives to improve and align safety, efficiency and environmental approaches driven by Single European Sky (European Commission, 2018) have strengthened competition between airlines and gave rise to Low Cost Carriers such as Ryanair, Norwegian Air Shuttle and easyJet (Erkelens, et al., 2017). On a global level, EU negotiations and agreements with ASEAN, The UAE, and Turkey additionally contributed to the liberalization

0,00% 5,00% 10,00% 15,00% 20,00% 25,00% 30,00% 35,00% 40,00%

Oneworld SkyTeam Star Alliance Non-Aligned

Leading Airline Alliances in 2016, by Market Share

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of the markets and increased competition, as EU airlines can now take part in emerging economic markets, while within the European market, Middle East carriers have increased their presence (European Commission, 2016).

Other relevant political factors relate to Brexit and unstable political environments in Northern Africa and the Middle East. In the process of The UK exiting The European Union, access to the UK market and competition from UK based airlines are yet to be established. However, it is clear that the same benefits of an open market as within the EU cannot be enjoyed, which has caused airlines to overcome these obstacles, such as easyJet (a London-based company) establishing easyJet Europe to continue its European operations. Furthermore, war and unstable political environment limits access and operations in Northern African countries and some Middle Eastern countries and pose threats to Lufthansa and other airlines operating at those destinations and airspaces. However, these developments only have a small impact on Lufthansa’s operations, as the company’s main market is still within Europe.

3.2.2.2 Economic

Air travel has faced growing demand over the past 13 years as shown in Figure 10.

Figure 10 - Annual Growth in Global Air Traffic Passenger Demand from 2005 to 2018, Own Depiction Based on IATA (2017)

With only a small downturn in 2009 in light of the financial crisis and a quick recovery afterwards, it can be argued that economic instability has a limited impact on demand for air travel. According to the International Air Transport Association IATA (n.d.), passenger air

8,90%

6,90%

7,90%

2,40%

-1,20%

8%

6,30%

5,30% 5,20%5,70%

7,30% 7,40% 7,50%

6%

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2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017F 2018F

Annual Growth in Global Air Traffic Passenger Demand from 2005 to 2018

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travel demand is forecasted to further grow over the next 30 years. Several economic factors should be considered in relation to this forecast.

Firstly, emerging markets such as Brazil, China and India experience large economic growth and an increasing middle class. More wealth enables larger parts of the population to travel and provides growing customer segments for airlines. Passenger growth in recent years has on average increased more than 10% per year in China and India, while India is additionally expected to be one of the largest commercial aviation markets by 2020.

Moreover, the number of international tourist arrivals worldwide grew 3.9% more than the overall GDP, with similar 4% yearly growth expected to contribute to the worldwide GDP in the future (Boeing, 2017). This expected growth over the next years shows that travelling is becoming an essential part of daily lives and that it is becoming less sensitive to financial fluctuations.

Other economic factors influencing the airline industry are those related to costs that airlines incur, particularly the fuel and labor costs. Fuel expenses are airlines’ largest input costs. While decreasing crude oil prices can be profitable to airlines as it reduces costs, it can also pressure airfares downwards, with then increased flight demand making airlines to increase capacity by investing in more airplanes (Macquarie, 2016). Consequently, it is viable for airlines to balance between profiting on low crude oil prices and still be able to handle increased capacity when oil prices increase again.

The second largest operating expense impacting the airline industry is labor (European Commission, 2017). Observed strikes in Europe relating to Lufthansa as well as other airlines regarding pension plans and wages indicate the sensitivity of labor relations. Air crew and handler’s requests for better labor conditions pose a larger threat on the airline industry’s costs and profitability. This factor will be further examined in the next section.

3.2.2.3 Social

In extension to previously mentioned factors relating to labor conditions and wages in the airline industry, these are additionally relevant when analyzing social factors. Strikes across Germany from pilots demanding pay rises led to a more than two years dispute lasting from 2014 to 2016 (TheLocal, 2016). In addition, wage and working condition dispute with cabin crew led to a walk-out in November 2015, forcing 4,700 flights to be cancelled (European

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Commission, 2018). Such disputes have been seen in most of Northern Europe over the past ten years in response to the airlines’ attempt of cutting costs in order to compete with Low Cost Carriers’ prices. Although perception of underpaid labor and poor working conditions are debated, demand for low airfares and the emergence of Low Cost Carriers are still increasing.

This also highlights passengers’ changing demand in air travel, which is becoming more of a transportation commodity in which passengers are willing to compromise additional service such as inflight entertainment, check-in luggage and meals in order to get a lower air fare. One group of passengers to whom cheap tickets are particularly important are young travelers.

Airlines need to meet demand of this passenger group with low airfares, however, more flexible travelers. This is seen for Lufthansa offering tickets with student discount and SAS creating cheap SAS Youth tickets, for passengers under 25 years, travelling on certain weekdays.

3.2.2.4 Technology

Advancements in technology have a significant influence on aviation and the airline industry.

Systems to manage data, track flights and improve communication and coordination, increases efficiency for aviation players, such as enabling quicker turnaround, minimize excess capacity in aircrafts and market to the right customer groups.

Moreover, the use of the internet has had a great impact on the airline industry. While on the one hand, the ability for passengers to easily find and purchase tickets online positively impacts the airline industry as access to flying is increased and the ability for airlines to target customers on the internet additionally increases passengers travel demand, on the other hand, passengers’

ability to compare prices and services of airlines can be thought of as a driver for focus on airfare costs, fueling the emergence of the Low Cost Carriers’ business model.

Another impact that technological factors has had on the airline industry is the development within aircrafts, in which increased speed, lighter aircrafts and less fuel usage impacts the performance of airlines and allows for lower costs for trips. Additionally, technological advancements increase safety standards and passenger comforts, another driver to increasing air travel demand.

3.2.2.5 Legal

In the aftermath of the 9/11 attacks, safety has played a major role for legal frameworks and regulations for aviation. Regulations relate to passenger lists requirements, limited access to

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aircrew members on airplanes, and limitations on amount and content of luggage. This led to significant increases in administration costs for airlines (IATA, 2011).

Other legal factors include regulations on crew and employees’ working conditions. States regulate companies’ and airlines’ employee wages and pension plans through minimum wages and pension payment legislations, consequently affecting the operational costs of airlines. Such regulations vary across Europe, in which Northern Europe has higher minimum wages and pension payments. During the past ten years it has been seen that airlines are hiring air crew members and other employees from Eastern European countries and moving their bases in these countries known for having lower required wages. Regulations regarding air crews’ working conditions in terms of required resting hours, amount of work days, whether employees pay for own sick days, also vary across states. These additionally affect airlines’ operating costs and impact the airline industry, as airlines have the tendency of hiring from countries with less regulations.

A last factor related to technological impacts are laws regulating airlines’ management and handling of personal data to protect passengers and customers. Technological advancements enabling airlines to obtain personal data, and legal guidelines of safety requiring airlines to do so, resulted in additional rules and regulations about how the airlines protect the data, and are costly in terms of the carrier’s image and heavy fines from governmental bodies, if data is not properly protected.

3.2.2.6 Environmental

Increased focus on pollution and environmental impact associated with aviation has led players in the industry to work towards common goals to decrease CO2 emissions, as aviation is responsible for around 2% of man-made CO2 emissions. The International Civil Aviation Organization under the United Nations, governing international aviation, has set three goals for a sustainable future in aviation. These goals are related to new aircrafts, engine technologies and research on fuel alternatives, more efficient airline operations and infrastructure management, as well as a framework to measure and control CO2 emission and to further increase fuel efficiency in order to stabilize and reduce CO2 emissions (Boeing, 2017). Similar frameworks are adopted within the European Union and other single nations, requiring airlines to consider and invest in new technologies and aircrafts to operate more sustainably and efficiently.

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3.2.3 Porter’s Five Forces

Lufthansa’s industry is further analyzed by applying the framework of Porter’s Five Forces.

The five forces consist of the threat of new entrants and substitute products, bargaining power of suppliers and customers as well as the intensity of rivalry between established competitors in the industry. These forces and threats impact the profitability of the industry and can lower its appeal. Lufthansa offers flights on a global level, however, based in Germany and operating mainly within Europe on short haul flights and from Europe to overseas destinations on long haul flights, this analysis primarily focus on the European airline industry. Figure 11 assesses Lufthansa’s industry based on Porter’s Five Forces.

Figure 11 - Porter's Five Forces for Lufthansa

3.2.3.1 Bargaining Power of Suppliers

In industries with a low number of suppliers, their bargaining power is often high, enabling them to set prices and impact profits. This is arguably the case for the airline industry as limited suppliers provide large (full-body) aircrafts and technology required. Airlines depend heavily on the duopoly industry of American Boeing and European Airbus to provide passenger jets, indicating extreme dominance of those two players. Furthermore, airlines are highly dependent on aircraft fuel, which is sold by major oil companies. Usually, long-term agreements between airlines and those companies exist and airlines hedge prices by making pre-agreements with oil companies on a certain oil price for a given time period.

Considering Lufthansa’s position in Germany, it is also relevant to emphasize the high bargaining power of labor in Germany, as labor unions have a strong position and can initiate

0 1 2 3 4 5

Bargaining power of supplier

Bargaining power of buyers

Threat of new entrants Threat of substitutes

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strikes and disputes concerning wages and working conditions. Recent disputes between Lufthansa, the pilot labor union and the cabin crew labor union have caused strikes and walkouts, leading to the cancellation of more than 4,700 flights (TheLocal, 2016) as discussed in Section 3.2.2.3. Conclusively, the overall bargaining power of suppliers is assessed to be high.

3.2.3.2 Bargaining Power of Buyers

Similarly, buyers bargaining position is strong when they can exert pressure on prices and impact industry profits. Single buyers in the airline industry, being consumers and business account holders, have low bargaining power due to their small size and the large number of middlemen such as travel agencies. However, switching costs below airlines are low when another company can fly the same route, while customers’ price sensitivity and the range of similar offered products is high. Consequently, customer’s similar perceptions of airlines together with requests for low airfares puts pressure on airlines to meet this demand. This can be observed in the airline industry, as Low Cost Carriers have increased their position in the market in recent years and network carriers have utilized low cost subsidiaries to keep prices low.

However, bad reputation of an airline, including punctuality, safety, and quality of services can prevent customers from choosing a particular airline. Furthermore, business travelers are less price sensitive than leisure travelers, but according to Eurostat, their demand in most European countries decreased in recent years.

Nevertheless, low switching costs for passengers and product similarity in the industry put pressure on network airlines. Therefore, buyer’s bargaining power is considered relatively high.

3.2.3.3 Threat of New Entrants

Profitable industries attract new entrants, which then may push down prices and profitability.

However, complications and costs related to high entry barriers lowers threat of new entrants.

High capital investments in aircrafts and technology are required to operate in the flight market.

Boeing and Airbus are the two main suppliers of passenger jets, for which costs related to production, testing, R&D and services are high (Grant, 2015). In this regard, high entry and exit costs for airlines are related to the intense capital investments in airplanes, as well as contractual obligations with suppliers and passengers.

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Airlines can benefit from economies of scale through large market shares, allowing companies to spread administrative costs onto more outputs and strengthen their negotiating positions with suppliers for lower prices (Grant, 2015). Additionally, as will be seen in Section 6, profit margins in the industry are rather low, making it somewhat unattractive for new players to enter the market.

Furthermore, product differentiation can lower the threat of new entrants as they face costs associated with marketing and creating a customer base. Established carriers can take advantage of brand recognition and customer loyalty (Grant, 2015). Network carriers such as Lufthansa benefit from flight connectivity and frequency through established networks.

However, low barriers of entry come from access to distribution channels and regulations. New entrants have easy and direct access to customers and buyers due to the internet enabling low distribution costs. Over the past 20 years, liberalization in the aviation industry has lowered entry barriers. Within the European airline industry, the launch of Single European Sky allowed airlines within the European Union member states to operate across borders without further permission requirements, making it easier for foreign airlines to enter the market.

For new entrants, it is important to gain access to landing slots at and routes between important airports. These are controlled by airports, governments and the European Union, which regulate competition.

In this regard, threat of new competition is present, however, not considered as a big threat to established airlines.

3.2.3.4 Threat of Substitute Products

In industries were customers are able and willing to pay for a similar product, the threat of substitute products is high. In the case of the airline industry, a substitute product does not include a flight with another carrier, but means another mode of transport. Consequently, substitutes mainly refer to trains and busses. The threat of customers choosing to travel by bus or train can in some instances be argued to be high, particularly on short-haul and domestic flights and if airports are located far from the customers’ end destinations. This is evident with the rise of low cost bus trip operators such as Flixbus, and the rise of fast speed trains as observed in Europe (Rahmann & Schlesiger, 2017). On the other hand, low air fares, as well as high frequency and connectivity of flights, particularly within Europe, strengthen air travel. On

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long haul flights, the threat of substitutes is arguably non-existing. Increased demand for flights indicates that passengers in general are less willing to switch to a substitute product of a flight.

Therefore, the threat of substitute products is considered very low.

3.2.3.5 Competitive Rivalry

The degree of competition among established companies in an industry impacts profitability of the industry and the overall competition. In some industries, high rivalry drives companies to compete on low prices, while in other industries competition is based on differentiation, marketing and innovation (Grant, 2015). Various factors are relevant to consider when analyzing the competitive level in the airline industry. The concentration ratio (CR4) indicates whether an industry is dominated by a few big players or fragmented with many smaller players (Boeing, 2017). Dispersion on the global market is seen in the concentration ratio of 12.6% for the four largest airlines in 2017, as shown in Figure 12, with Delta Airlines servicing 4.4% of the market, followed by United Continental Holding, Deutsche Lufthansa and American Airlines (Euromonitor, 2017).

Figure 12 - Global Market Share by Retail Sale Price (RPS) in 2017, Own Depiction Based on Euromonitor (2017) 4%

3%3% 3%

2% 2%

2% 1%

1%

78%

Global Market Share by Retail Sale Price (RSP) in 2017

Delta Air Lines Inc

United Continental Holdings Inc Deutsche Lufthansa AG

American Airlines Group Inc Southwest Airlines Co Emirates Airlines

Air France-KLM Group SA International Airlines Group China Southern Airlines Co Ltd Air China Co Ltd

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In Figure 13 it can be seen that, obviously, the European market is less dispersed at a CR4 ratio of 55% in 2017, with Lufthansa and Ryanair both holding a market share of 16%, followed by IAG (13%), easyJet (10%) and Air France-KLM (9%).

Figure 13 - European Airlines Market Share in 2017 (Based on Available Passenger Seats), Own Depiction Based on (BDL)

Both markets indicate intense competition, which is intensified considering competitors diversity and product differentiation. Differences between companies and their products offered determine the extent to which companies will compete aggressively on prices, as switching costs are usually lower for very similar products (Grant, 2015).

Two types of carriers can be distinguished in the European airlines industry; the low cost carriers and network carriers. Network carriers differentiate themselves from low cost carriers by including added services in terms of rebooking possibilities, connectivity etc., while low cost carriers, operating mainly on short-haul distances, offer point-to-point flights with limited extra services. Competition amongst network carriers themselves is relatively low as their hubs, which describes the airport from which they operate most of their flights, are placed to serve different geographical markets. Examples are Lufthansa mainly serving the German market through hubs in Frankfurt and Munich, and SAS serving the Scandinavian market through hubs in Scandinavia. However, competition from low cost flights has driven network carriers to utilize subsidiary carriers to operate short haul flights, and they are also expected to enter the long-haul segment in the near future. Moreover, as seen before, competition has risen from Middle East carriers utilizing their geographic position to directly fly from Europe to South

16%

13%

10%

9%

36%

European Airlines Market Share in 2017, Based on Available Passenger Seats

Lufthansa Group Ryanair

IAG easyJet

Air France-KLM Others

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East Asia and other destinations (Boeing, 2017). To sum up, relatively intense competition can be seen within the European market.

3.3 Internal Factors – Competitive Position 3.3.1 SWOT Analysis

To further assess the competitive position of Lufthansa, a SWOT analysis is conducted, including a full value chain perspective of Lufthansa covering logistics, operations, marketing

& sales and services along with a range of financial, organizational and strategic perspectives.

A SWOT analysis addresses both internal and external factors influencing a company’s business environment by looking at the company’s strengths and weaknesses in their business operations, as well as opportunities and threats evolving from the market environment (Harrison, 2010).

3.3.1.1 Strengths

Lufthansa’s key strength is its position as a leading global network carrier, being the 3rd largest airline by revenue in 2017 (Euromonitor, 2017) and 8th largest airline by Revenue Seat Kilometers (RSK) in 2017 (Statista, n.d.). This is achieved by a global network coverage and a well-diversified route network, which is one of the largest worldwide. The strong market position (market share of 9% (Lufthansa, 2017)) in the European airline sector and leading domestic market position in Germany is supported by Lufthansa’s hubs in Frankfurt, Munich, Zurich, and Vienna (Listowska, 2017). This multi-hub strategy gives customers a broad range of travel options (Stäblein, 2016).

Additionally, even though Lufthansa’s main market is located in Germany, its geographical diversification reduces the dependency on developments of local economies. Downturns and recessions in one or more single markets can be offset by booming economies in other countries and regions. Spreading out their business activities across different geographical market also protects Lufthansa from localized event risk (Moody's, 2017).

Furthermore, Lufthansa is a co-founding member of the Star Alliance network, a co-operation of 28 member airlines (Lufthansa, n.d.). Customers benefit from a worldwide reach and a smooth travel experience. Member airlines often coordinate their schedules, resulting in shorter journey times for passengers, offer overall validity of frequent flyer programs as well as privileges with check-in and luggage. Additionally, member airlines, like Lufthansa, not only

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benefit from a higher perceived service level by passengers, but can also exploit synergies and reduce costs when operating in a global network, as the airlines usually offer common check- in facilities in the same terminal and mutual access to their lounges. As a result, not every airline needs to offer each facility at each airport, but can make use of the other member’s facilities, and therefore reduce their costs (Lufthansa, n.d.).

Another important strength of Lufthansa lies in its business strategy. The company has a well- diversified business profile with leading market positions not only in the passenger and cargo business, but also in the MRO and airline catering segments. This reduces Lufthansa’s exposure to volatility and cyclicality in the passenger and cargo traffic and adds stability to the Lufthansa Group’s earnings (Moody's, 2017).

In the passenger business segment, Lufthansa benefits from its brand strength of the airlines Lufthansa German Airlines, Swiss, Austrian Airlines, and Brussels Airlines, as well as its multi- passenger branding. The airlines offer both luxury and economy cabins and operate on long haul and short haul flights, which balances across its route portfolio.

Also, Lufthansa caters different customer groups with different airlines. A high service level is important for premium brands like Lufthansa German Airlines and Swiss, leading to a high share of business travelers at those airlines. The complementary services at those airlines include in-flight drinks and meals, free check-in and seat selection and free checked luggage allowances (Stäblein, 2016). Eurowings, the low-cost airline in Lufthansa Group portfolio, however, addresses both price-sensitive and service-oriented customers with low-cost basic fares and additional service options by a point-to-point traffic strategy. In a point-to-point traffic system, customers travel nonstop from one city to another (from origin to destination), versus in a hub-and-spoke system (mainly used by network carriers), one or a few central hubs connect origins and destinations, as explained by Figure 14.

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Figure 14 - Point-to-Point vs Hub-and-Spoke System, Based on (Schule für Touristik, 2017)

In a point-to-point system, the customers benefit from lower connection and travel times and no interdependency of flights. This is also an advantage for carriers such as Eurowings, as in this system flights are at a lower risk to be delayed, leading to lower costs for those airlines (StanfordPress, 2016). Eurowings transition to a point-to-point traffic system enables it to better compete with other successful low-cost airlines. However, network carriers like Lufthansa German Airline still make use of the hub-and-spoke system, as this allows them to cover a larger network of destinations (Cook & Goodwin, 2008).

3.3.1.2 Weaknesses

Lufthansa is operating as a premium carrier with a high customer service level, which leads to higher cost positions and therefore a competitive disadvantage for the company on a financial side (Listowska, 2017). Even within Europe, Lufthansa ranges amongst higher cost airlines (in terms of costc per available seat kilometer), leading to a lower Group profitability than its peers (Bhasin, 2017).

Also adding to costs for Lufthansa Group are significant and volatile pension obligations due to a fluctuating discount rate. As of December 31st, 2017 those obligations accounted for almost 50% of total adjusted debt (Lufthansa Annual Report, 2017) and a further increase would lead to a substantial change in Lufthansa’s financial leverage ratios. In an environment of low interest rates, having underfunded defined benefit plans can become a significant challenge for the company, as it raises the cost of funding retirement benefits. “The enormous pension burdens are putting considerable pressure on our equity” (Menne - Lufthansa CFO, 2015, p. 1).

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However, Lufthansa implemented proactive measures to lower those pension obligations and exposure to interest rates. These measures include a permanent reduction of pension obligations due to a new defined-contribution pension plan for cabin crew staff (agreed in June 2016), and pilots (agreed in March 2017), as well as cash injections into the pension scheme (Listowska, 2017).

The aforementioned agreements followed years of strikes and debates about pensions, salaries and working hours by Vereinigung Cockpit union, which represents about 5,400 pilots of Lufthansa Group. The strikes made clear the poor labor relations, another weakness of Lufthansa Group (Bryan, 2017), and also occasionally affected Lufthansa’s operating performance, because the strikes and labor disputes led to several delays and cancellations of flights (Deutsche Presse Agentur, 2016).

However, Lufthansa’s somewhat low profitability, which will further be assessed in Section 6, is not only driven by pension liabilities, but also depends on external factors including uncertain oil and fuel prices as well as economic developments in Germany and Europe. Especially oil prices are very volatile and difficult to predict, but Lufthansa tries to hedge their exposure to oil price fluctuations continuously in order to reduce the associated risks (Lufthansa Annual Report, 2017).

On a strategic side, Lufthansa’s market position is challenged by Low Cost Carriers in the short- haul segment and Middle-Eastern airlines in the long-haul segment, as discussed in Section 3.2 (Listowska, 2017).

Furthermore, most airlines of Lufthansa Group operate a multi-hub strategy. The most important disadvantage of this strategy is the lower flexibility to adjust capacities without influencing the overall system, as in this system, travel schedules are timed and interconnected (Stäblein, 2016).

3.3.1.3 Opportunities

However, numerous opportunities exist for Lufthansa to pursue. Lufthansa German Airline’s business model is based on offering premium services. This is in line with the airline’s aim of becoming Europe’s only five star rated airline by Skytrax, which it achieved in December 2017.

“The award is a well-deserved recognition of our major efforts to make Lufthansa one of the world’s leading premium airlines again. […] The combination of premium offerings with the

Valuation of

Valuation of

and the Changing Market Environment Following the Insolvency of Airberlin

Contents

1 Introduction

2 Methodology

3 Strategic Analysis