Wolf Richter is the CEO of Wolf Street Corp. and the editor-in-chief at Wolf Street, where he muses about economic, business, and financial issues, Wall Street shenanigans, European entanglements, and other things, debacles, and opportunities in the US, Europe, Japan, and occasionally China.
In 1967, Icelandic airline Loftleiðir started offering cheap tickets on Transatlantic flights. Loftleiðir used a lot of what today would be called “funny business practices” to offer such low fares, such as flying the Canadair CL-44, an unsuccessful cargo plane converted into an all-passenger configuration, and not being exactly concerned with punctuality or speed. It was an instant success.
Loftleiðir did not survive the 1970’s, being absorbed by Flugfélag (now Icelandair), but the seed had been sown: the low-cost carrier (LCC) had been born.
Loftleiðir specialized in what the European Organization for the Safety of Air Navigation (Eurocontrol) defines as “long haul flights,” meaning over 4000 km (about 2,500 miles), but success really came to the LLC model on “short-haul” flights (under 1,500 km) and “medium-haul” flights (between 1,500 and 4,000 km), with companies such as Ryanair and IndiGo having now become veritable behemoths.
Low-cost carriers (as defined by IATA) accounted for 44.8% of passenger traffic in the EU, 52.6% in South-East Asia, and 57.2% in South Asia. Legacy carriers, meaning “conventional” airlines such as American Airlines, Air India, or Air France are either feeling the pinch or are joining the fray with their own low-cost divisions, such as Transavia (KLM) and Peach (All Nippon Airways).
However, the long-haul segment continues to remain elusive for LLCs.
But this is the age where credit is cheap, especially for “below investment grade” (“junk”) rated companies. And since low-cost long-haul flights remain an “untapped business segment,” there’s no shortage of starry-eyed hopefuls.
In a recent interview, Bob Crandall, former American Airlines CEO who led the brutal and ultimately successful counterattack of legacy carriers against upstart LLCs such as Laker Airways and PeoplExpress, said that this will be a matter of “who’s going to be prepared to lose the most money,” and it seems current developments are proving him correct.
AirAsia X, the long-haul arm of LLC AirAsia (whose majority owner is Malay godfather Anthony Fernandez), has been bleeding red ink since its much heralded 2013 IPO on the Kuala Lumpur stock exchange, at the lofty price of MYR1.35. It is now languishing at a miserable MYR0.24.
Despite poor financials and declining share prices, AirAsia X remains strongly committed to expansion at all cost.
To give you an idea of what kind of expansion we are dealing with: AirAsia X has ordered an absolutely amazing 100 Airbus A330-900neo models. At a list price of $296 million, this would amount to nearly $30 billion, but large discounts certainly apply.
By comparison, Delta Airlines has just 25 A330neo models on order and Garuda Indonesia a measly 19. How AirAsia X is going to be able to pay for all these expensive airliners, keep them in the air, fill them with passengers, and turn a profit remains a very interesting question.
To this must be added that the AirAsia X order was instrumental in getting the struggling A330neo program off the ground as it risked being choked to death by the smashing success of the completely new Airbus A350 after Airbus sank €2 billion into it. So a lot is running on this fragile deal.
And no discussion of long-haul low-cost carriers would be complete without what I have dubbed “the Netflix of the Skies,” Norwegian Air Shuttle, or simply Norwegian, whose fleet has grown from 6 planes in 2002 to 164 now.
The whole business model of Norwegian is the subject of much debate and rivers of ink, real and virtual alike, so here I’ll briefly focus on the long-haul arm, Norwegian Long Haul.
Norwegian Long Haul presently operates 8 Boeing 787-8 and 11 787-9 (the “standard” and “stretched” variants respectively) with a further 11 on order. And that’s big money: the 787-8 is $239 million each at list price, while the 787-9 is $281 million at list. And that’s just for the aircraft themselves: On top of that there are crews who need to be paid and trained, insurance, fuel, maintenance and all the usual costs associated with running an airline, such as landing fees.
Norwegian has been driven by what can only be called an extremely aggressive expansion policy. Premium-class seats on a standard London-New York flight are just 34% more expensive than their already cheap economy-class seats – well below the industry standard. The addition of those planes has created more capacity. And competition from legacy carriers such as American Airlines and British Airways has further reduced pricing power.
This aggressive expansion resulted in some, shall we say, peculiar financials for 2017 which attracted the attention of Norwegian fiscal regulators and led to truly mind-boggling losses. Bjorn Fehrm of Leeham News estimated in the first half of 2018, Norwegian had an operating loss of NOK 5.2 billion (about $690 million), or 50% of revenue.
To raise short-term liquidity, the company has sold most of its shares in Norwegian Bank (down from 20 to 4.8%) and sold 28 of their Boeing 737-800s and rented them back from the new owners. While this raises a lot of cash up front, it comes with higher costs mid-term, as Alitalia discovered all too painfully. It ended up in the Italian version of bankruptcy in 2017.
How long can a company last in such conditions, even in an financial environment of plentiful and cheap debt, is anybody’s guess.
That is why Norwegian Long Haul is at the center of a complicated game of chess between three of Europe’s largest airline groups: Lufthansa, Air France-KLM, and IAG, the common holding company for British Airways and Iberia.
All of these groups already operate short- and medium-haul LLC’s with varying degrees of success, but long-haul remained off the book until last year when Air France, faced with the realization about a third of its long-haul routes were unprofitable, decided to adopt a low-cost approach to them. The new brand, JOON, started operations in December 2017. And it has already caused a stir.
This year IAG launched operations of a new brand, LEVEL (don’t ask me why all these new brands are written in capital letters), which should become the long-haul “sister” to Vueling. But so far, long-haul services are merely ordinary Iberia flights and the brand operates as just another leisure airline, carrying passengers from Austria to vacation destinations around the Mediterranean using Airbus A321s obtained during the Air Berlin liquidation process.
That’s where Norwegian Long Haul comes into play.
In April 2018, IAG took a 4.6% stake in Norwegian and announced they were “considering” taking over the company. At about the same time, Lufthansa expressed similar considerations.
However, there are several problems with a full takeover of Norwegian, chief among which is fleet compatibility: Norwegian operates a 100% Boeing fleet (though it has some Airbus on order now) while both IAG and Lufthansa operate 100% Airbus LLCs.
Lufthansa shareholders are already fretting: While the core business segments (led by IT and catering) remain highly profitable, the group is in urgent need of reorganization due to having absorbed too many ailing airlines in too short of a time. This reorganization will have to include a deep rethinking of the fleet, which remains “a logistic nightmare.”
So far, aircraft and crews have been juggled throughout the group. But soon painful choices will have to be made. The Lufthansa fleet includes everything from the aging McDonnell Douglas MD11F of the cargo division to the new Airbus A350-900 used on long-haul routes such as Frankfurt-Mexico City. Adding more aircraft types at this point is not an option to be exercised lightly.
IAG already operates a growing Boeing 787 fleet through British Airways and doesn’t suffer from the same brand “crowding” as Lufthansa. A takeover of Norwegian Long Haul would fit nicely in their strategy and allow them to get into the long-range LLC business quickly.
Because time is of essence: Interest rates are already starting to tick upwards as financial markets get squeezed between somewhat less accommodating monetary policies and the rediscovery of risk. Funding for such adventures is starting to get more expensive. And once the present window of opportunity is closed, it may remain so for a long time and with it the possibility to making long-haul LLC’s a viable business model. By MC01, a frequent commenter on WOLF STREET
Converting used passenger aircraft to freighters is a booming business, but overcapacity looms. Read… What’s Going on in the Used Passenger-Plane Market?
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