The Kuehne-backed Lufthansa value pinnacle. Or?
News yesterday that a settlement with pilots at Eurowings, Lufthansa’s regional carrier, will run for five years proved to be a step in the right direction for Germany’s biggest airline.
Agreement has also been reached with Austrian Airlines, Swiss International Air Lines and Lufthansa CityLine, but “still outstanding, however, are wage agreements at Lufthansa German Airlines, Lufthansa Cargo and Germanwings,” Lufthansa said.
So the carrier still has problems, but not as bad as those of Air France-KLM. The latter is seriously troubled, and may even struggle to continue to operate as a going concern, unless it undertakes a massive cost-cutting plan or raises new equity capital, as The Loadstar argued last week.
Germany’s flagship airline is stronger than its French rival both financially and operationally, although costly strikes, falling yields and raging competition for market share in Europe’s skies have been a big headache for shareholders, who are now faced with the risk of additional capital losses and a zero dividend policy.
In cargo, Lufthansa has been one of a few carriers to actively invest – in sharp contrast to its Franco-Dutch rival.
Although it saw volumes decline 2.7% in 2014, year-on-year, it said it had been attempting to boost yields. Its Cargo 2020 plan is on track, “despite the difficult framework conditions” said CEO Peter Gerber. Its IT system is being rolled out worldwide, while the new Frankfurt air freight terminal is under way. And, of course, it is exploring partnerships such as its strategic joint venture with All Nippon Airways.
Negative working capital gives Lufthansa prompt access to short-term funding. Meanwhile, its short-term liquidity profile is reassuring, with a decent debt maturity profile. Furthermore, its amended depreciation policy last year added more than a third of a billion euros to the operating profit (Ebit).
Is all this too good to be true?
Well, consider this: on an aggregate basis, between 2011 and 2013, Lufthansa generated about €1.4bn of core free cash flow, as gauged by operating cash flow minus capital expenditures (capex). However, its free cash flow yield for 2014 should be very close to zero, according to The Loadstar’s estimates. In fact, Lufthansa should churn out core cash flow from operations of about €2.7bn in 2014, but roughly the same amount should be invested in capex. Quite simply, Lufthansa may generate very little free cash flow this year, or could even end up burning cash, particularly if more strikes take place.
Inevitably, its dividend policy should come under scrutiny.
When, in early 2014, Lufthansa reinstated dividends for fiscal 2013 with great fanfare, managers argued that the success of the group’s turnaround story showed in its operating results, and it was a great sign of confidence for the years ahead. In fairness, strategically, the decision to announce a 2013 dividend per share of €0.45 in 2014 wasn’t very clever, although it was praised by several analysts at the time. The payout ratio was about one third of Ebit last year, but given that Lufthansa spent €207m in dividends, the dividend cover stood at a lowly 1.5x.
Another basic element suggesting caution back then should have been a full-year net profit fall of 74.5% to €313m. “Future dividend policy needs to be reviewed to reflect higher operating profits due to new depreciation policy,” Lufthansa said at the time.
That’s only part of the story. What a difference a year can make.
In the first nine month of 2014, operating cash flow plunged to €2bn from €3bn, it emerged at the end of October. In early December, the announcement of a reduction in the payout ratio ensued.
“Germany’s largest airline said it would begin paying out between 10% and 25% of earnings before interest and taxes, or Ebit, to investors in dividends starting next year,” The Wall Street Journal reported on December 10.
Questions remain as to whether Lufthansa should pay dividends at all, and if its cash flow profile doesn’t improve materially over time, I would not be surprised if it announced a zero dividend policy in the near future.
Since the appointment in May of former cargo chief Carsten Spohr as CEO, Lufthansa has been hit by two profit warnings, which contributed to bring the shares sharply down on both occasions. The stock has lost more than 20% of value over the period, but at one point back in October, it had almost halved to about €10 in less than half a year. Scary stuff.
Now trading at €15, the shares of Lufthansa change hands slightly above the average price target from brokers. Only if top-end estimates from analysts were met, they could surge to €22 over the course of 2015 – which is highly unlikely, in my view.
“Midway through Lufthansa’s three-year cost-cutting drive, investors and analysts are looking to Carsten Spohr to keep focused on paring expenses and boosting profits,” wrote the New York Times in March 2014, in a story headed “Lufthansa results suggest overhaul Is paying off”.
This week, Barclays reiterated a positive stance on European airlines, with particular emphasis on Lufthansa, adding that investors do not fully appreciate the earnings benefits that falling oil prices may bring to airliners.
But the counter-argument here is obvious: a sluggish GDP growth in the Eurozone, which is faced with deflation, and rising costs of travelling for the consumer may offset most short-term benefits stemming from lower oil prices, which, in several cases, have already been hedged for the rest of this year.
For Lufthansa, fuel costs amount to about 20% of its total cost base and, as the carrier said less than 12 months ago with regard to fuel price risk, up to 5% cent of exposure is hedged monthly for up to 24 months by spread options and other combinations of hedges, for a maximum hedging level of 85%. Lufthansa will partly benefit from lower fuel bills, of course, but the full benefits of structurally lower oil price may show in 2016, or later.
One option to support its dividend policy would be to seek buyers for some of its assets, those in the bear camp argue.
Is the cargo unit, for instance, a good divestment candidate? If Lufthansa were able to fetch a valuation for the unit in line with its own enterprise value/forward sales of 0.33x, it could fetch €825m, although, as we learned last week in Air France-KLM’s case, such businesses are hard to sell, and they will unlikely attract buyers eager to secure traffic rights and limited growth — last year, a +1% growth for the unit was driven by increased belly capacity.
And with the investment the carrier has made in cargo, a fire sale to finance the dividend seems out of question.
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