DLAKY - Lufthansa: Takeover Of ITA Carries Execution Risk But Makes Strategic Sense

2023-05-30 03:55:43 ET

Summary

• The take-over of the Italian national airline makes strategic sense for Lufthansa Group but comes with significant execution risks.
• Despite a net loss in Q1 2023, Lufthansa Group's outlook for the year is positive.
• Current risk/reward ratio for new investments is unfavorable at the moment due to risks and the elevated share price.

(Note: all amounts in the article are in EUR. At the current exchange rate 1 EUR is around 1.07 USD.)

Investment Thesis

Lufthansa ([[DLAKF]]; [[DLAKY]]) has reached an agreement with the Italian government to take over 41 percent of the Italian national airline ITA Airways through a capital increase of 325mn euros.

ITA Airways is currently fully owned by the Italian Government (the Ministry of Economy and Finance to be exact). The airline has approximately 4,000 employees, services more than 10 million passengers per year and is running a relatively modern fleet of 66 Airbus aircraft. Its two main hubs are Rome and Milan.

Lufthansa has a history of acquiring smaller national airlines that were in financial trouble. While the results of those past acquisitions are not fully convincing, I think the deal makes strategic sense for Lufthansa. The airline consolidation in Europe is unlikely to stop and Lufthansa has very few opportunities to increase market share organically. Measured by the number of passengers transported, the low-cost provider Ryanair (NASDAQ: RYAAY ) is already far ahead of Lufthansa Group and Lufthansa is only a distant #2. Ryan Air is also more profitable .

After a net profit of 791mn in 2022 , Lufthansa Group reported a net loss of 467mn in Q1 2023. But the outlook for the rest of 2023 is much better. The airline expects to see continued recovery in demand and further increase in capacity. Still, the passenger segment is forecasted to be only between 85% and 90% of its pre-crisis level.

Shares are now just 15 percent lower than where they were in February 2020, when the COVID crisis hit. Therefore, and because of the significant execution risks the ITA takeover brings with it, I do not think the risk/reward ratio for new investments in Lufthansa is favorable at the moment.

Details of the agreement

Lufthansa is taking a 41 percent stake in ITA through a capital increase of 325mn. In addition, the Italian government is also going to inject 250mn additional capital into the company.

This goes back to an offer in the form of a letter of intent which Deutsche Lufthansa AG had submitted to the Italian Economics and Finance Ministry in January.

ITA will cooperate with Lufthansa Group to benefit from synergies such as access to the partner network, central revenue management and the use of Lufthansa Group's global sales and marketing channels. But the airline will remain a standalone entity with its own management and brand identity. This is obviously very important to the Italian government.

Lufthansa has a call option for a full takeover in the future, but no obligation to buy the rest of the airline. The purchase price will depend on the business development of ITA Airways. Details for that were not disclosed, but the timeframe is around 2025, so two years. Obviously, Lufthansa wants to make sure that a successful turnaround can be executed before it commits further money - which makes sense.

ITA Airways has approved a business plan and shared it with Deutsche Lufthansa AG, but the plan has not been publicly disclosed yet.

What comes next?

After its establishment in 2021 out of the bankrupt Alitalia airline, the new airline had published its current business plan covering the years 2021-2025. The plan, which does not seem especially imaginative to me, forecasted revenues of 3,329mn in 2025 and an operational break-even in Q3 2023. Both things are clearly not happening.

ITA has not made a profit for 20 years. The airline lost 486mn in 2022 on revenue of just 1.5bn. At the end of 2022 ITA had only 418mn cash and net equity of 524mn.

Under these circumstances the turnaround will certainly not be easy. Both Air France-KLM and Etihad have tried before and have failed - each of them had to completely write off their investment in ITA's predecessor Alitalia when after years of losses they did not want to put in more money. In case of Etihad it was an astonishing 1.76bn euros .

Lufthansa will probably have to do more than just integrate ITA into the group sales network to make ITA profitable. Synergies on all levels will have to be found and executed. And here lies the conundrum and risk for Lufthansa. The German airline is liked as an investor, especially by governments, because the airline usually allows acquisitions to keep their own identity and brand, as well as their own management. It did this with Austrian Airlines, Swiss Air, and Brussels Airlines. The Portuguese airline TAP could be next in line (but it actually made a small profit recently , so the Portuguese government could not be in such a hurry).

But to avoid a repeat of the failed Air France-KLM and Etihad engagements, the airline will probably have to intervene more rigorously in ITA more than with the previous acquisitions. That will be difficult because the Italian government will obviously be the majority shareholder, at least for a while. There will be hard choices to be made, and lots of opportunities for political pressure and compromise to get in the way of execution.

Past acquisition deals have produced mixed results for Lufthansa

Lufthansa has acquired other smaller national airlines in the past. It is almost something like the go-to airline for any European country that has a national airline which is not doing so well. The usual case is that national airline does not make any money, and has done so for a while, but the government neither wants to shut it down nor take drastic measures to fix things.

So far, the record of those acquisitions is mixed. Neither Brussels Airlines nor Austrian Airlines have been consistently profitable since Lufthansa took them over, but because of the COVID crisis over the last years it is hard to make a definitive judgment. So far only the Swiss Air takeover looks like it has clearly worked out well. The Swiss carrier is now performing even better financially than its parent company. For example, among the five passenger airlines in the group - Lufthansa German Airlines, Austrian Airlines, Brussels Airlines, Swiss Air, and the low-cost airline Eurowings - Swiss Air was the only one with a positive EBIT in Q1 2023 .

Conclusion

The acquisition of ITA is strategically correct - in my view. The airline group has few opportunities to grow market share outside of further acquisitions. Therefore ITA Airways was an opportunity that it could not let pass by.

But there are significant execution risks with ITA. Others have tried and failed before. It looks like Lufthansa is hedging its risk with only a minority stake for the next years. While this limits the financial commitment for now, this could be an issue as it leaves the Italian government formally in the driver's seat. The worst-case scenario would be that ITA keeps losing money and Lufthansa has the difficult choice of either pulling the plug and walking away or injecting more capital into the Italian airline.

My judgment here is: As Lufthansa itself is still recovering from the COVID crisis and even a very good fiscal year 2023 will not take it back to pre-crisis levels, the current share price and the risk/reward ratio are not very favorable for new investments in Lufthansa Group at the moment.

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