As the old saying goes, to quickly become a millionaire, start with a billion and acquire an airline. Handicapped by major hurdles — capital intensity, cutting-throat competition and powerful unions, among others — the challenges faced by the air travel industry need no introduction.
Remarkably, the paradigm may have started to change in some parts of the world, where a few major carriers came to dominate their markets in what resembles near-oligopolies. But situation is different in Europe, where five majors — Lufthansa, Ryanair, IAG, Air France-KLM and easyJet — compete against a myriad of smaller operators.
Consolidation is inevitable, and Lufthansa made it clear that it wants to participate. In 2018, buying Air Berlin in distress was a clear defensive transaction, effectively blocking any competitor from entering the so-called “fortress Lufthansa” territory.
Several observers claim that with a modernized fleet and better margins, the company has all the muscle it needs to turn its bold ambitions into reality. That may be true, but as of now, its financial standing resembles an eggshell, with €13bn in debt, pension and provisions — plus €18bn in purchasing commitments — against less than €3bn in operating earnings.
That is just the surface. Scratching beneath, it appears that reported IFRS earnings bear little resemblance with the company’s actual earning power. This is because depreciation and amortization expenses vastly understate capital expenditures, while expenses which are both significant and unpredictable regularly spring up with pension plans, hedges, provisions and financial assets revaluations, triggering enigmatic write-downs and reversals.
Absent a structural shift in the European air travel industry, Lufthansa’s conservatively assessed free cash-flow should average €1bn per year. Of course, high operating leverage, maximum exposure to economic cycles and unproven restructuring efforts at Eurowings — its low cost carrier — could severely dampen bottom line.
On an enterprise value basis, the company has historically traded at a multiple of ~x15 said earning power. In 2017, valuation spiked after a dividend increase and the unveiling of a new strategic plan, reflecting high expectations. Yet those were quickly brushed off. The share price is now back to its historical average.
Despite a privileged competitive position in the European heartland, where it controls major hubs, Lufthansa looks far from fighting fit. It must consolidate further if it wants to gain scale and pricing power, but its massive financial leverage entails substantial risk if indeed large acquisitions occur.
Poor returns on investments are likewise worrisome, for the cumulated €15.5bn in capital expenditures over the 2014-2018 period have yet to deliver a meaningful improvement in earning power. Future returns remain strictly impossible to assess, because no model can reliably help to provide even a rough figure of how much cash the business will be able to distribute over the next decade. There are just too many variables, the majority of which out of management’s control.
That also applies to acquisitions, in particular when the benefits of adding new routes via external growth versus greenfield development are dubious. What is known for sure, however, is that past returns have been awful, and that promises made by management in 2018 are strangely reminiscent with those they made some years ago.
Albeit cheap by certain yardsticks, at €15 per share, with an enterprise value of about €20bn, Lufthansa currently trades at x34 its average annual free cash-flow over the 2014-2018 period, and x14 its average annual free cash-flow during the fortunate 2016-2017 period. If the adherence to the concept of a margin of safety is what separates value investors from others, the stock is clearly uninvestable.
Of note: in 2018, free cash-flow failed to cover the dividend; the funding gap was offset by a large disposal of securities and fund investments. In 2016, substantial impairment losses were recognized on the sale of aircrafts; in this case, as in others, book value may thus be a flawed proxy of actual value.