In Fighting Trim

Europe's airlines have cut costs, so they're better off than U.S. rivals

Lufthansa (DLAKY ) Chief Executive Jürgen Weber was surprised when two United Airlines pilots showed up at talks between Lufthansa management and its pilots' union a few years ago. In 1997, United and Lufthansa founded global Star Alliance. The Lufthansa union's unspoken message: With United pilots on our side, we're unbeatable. Weber chuckles in an interview, recalling how he ran into the same Lufthansa union leaders not long ago. "I asked them: 'Where are your friends at United now?"'

Happily for Lufthansa, its flight path is nowhere near United's. While the U.S. carrier plunged into bankruptcy last year, Lufthansa made a $774 million net profit on $18.3 billion in sales, rebounding from a $683 million loss a year earlier. The German airline's debt is only $1.2 billion, compared with a staggering $21.3 billion at United. True, Lufthansa and other European carriers haven't escaped the turbulence buffeting the U.S. airline industry. Lufthansa warned on Apr. 9 that it would suffer "unexpectedly high" first-quarter losses because of a stagnant economy, the war in Iraq, and the outbreak of severe acute respiratory syndrome (SARS). But its troubles pale next to those of United, which is expected to post losses of more than $1 billion for the first quarter.

In fact, European airlines are looking surprisingly resilient these days. One big reason: While their American cousins have turned to the government for help, the Europeans are having to fend for themselves. When air travel went into a tailspin after the September 11 attacks, Congress coughed up a $5 billion cash bailout plus $10 billion in loan guarantees for ailing U.S. carriers. But European Union antitrust authorities refused to allow any government aid for the region's airlines. European carriers had to roll up their sleeves and go to work, slashing capacity, controlling labor costs, and reducing debt. "The Europeans really addressed their cost base," says Nick van den Brul, a London analyst with BNP Paribas. "In the U.S., once they got the bailout, they didn't seem to take their problems so seriously."

Certainly, the Europeans had some lucky breaks. They were less exposed than U.S. carriers to the disruption of traffic into and within the U.S. after September 11. Closer to home, the bankruptcies of Swissair and Belgium's Sabena in 2001 helped shrink excess capacity while enabling Air France and Lufthansa to take over the defunct carriers' most lucrative routes. And the old-line European carriers face only limited competition from low-cost carriers such as Ireland's Ryanair (RYAAY ) and Britain's easyJet Airline Co., because the discounters don't fly the longer-haul international routes that account for more than half of the big European carriers' business. U.S. airlines, by contrast, get well over two-thirds of revenues from domestic routes where low-cost competition is often fierce.

Still, there's no denying that Europe's flag carriers have shaped up. Take Lufthansa. In a country famous for tough unions and rigid work rules, it has negotiated some of the most flexible labor arrangements in the industry. On Apr. 15, less than a week after issuing its first-quarter profit warning, Lufthansa said it would reduce the work schedule of all ground personnel by 1.5 hours a week. That, along with planned reductions in working hours by cabin crew and pilots, could yield up to $20 million in savings this year. The reductions for ground personnel were made possible by a labor agreement signed in February that lets Lufthansa cut hours immediately if there is a slump in sales. Lufthansa says the agreement is the first of its kind in Germany.

With European carriers' traffic expected to slump as much as 20% this month because of the Iraq war and SARS, Lufthansa isn't the only one acting swiftly to cut costs. In late March, British Airways PLC (BAB ) announced it would cut 13,000 jobs by September, moving forward reductions that were to have taken place over the next 12 months. The British carrier also cut capacity by 4%, on top of a 20% reduction over the past two years. Scandinavian Airlines System (SAS) announced 4,000 job cuts on Apr. 10 as part of a savings package of up to $927 million. The same day, Air France and BA announced they would retire the supersonic Concorde from service this year because of declining demand and high maintenance costs. Such a move would have been unthinkable only a few years ago in France, where the Concorde is a symbol of the nation's technical prowess. Said Air France Chairman Jean-Cyril Spinetta in announcing the decision: "Operating Concorde has become a severely and structurally loss-making operation. It would be unreasonable to continue."

With hard-nosed management like that, the Big Three European carriers -- Lufthansa, Air France, and BA -- are well-positioned to grab weaker players further enfeebled by the downturn. One likely target is chronically unprofitable SAS, owned by the Swedish, Norwegian, and Danish governments. Already part of the Star Alliance, it may be absorbed in the next few years by Lufthansa, analysts say. KLM Royal Dutch Airlines is considered likely to link up with Air France, which is tightening links with Alitalia. These relationships will probably fall short of full-scale mergers because of national restrictions on foreign investors. But, says Daniel Solon, a Barcelona aviation consultant, "this market cries out for consolidation, and we're going to see it soon." Some smaller carriers, such as Swissair's successor, Swiss International Air Lines, are in such poor shape they may simply go out of business.

The Big Three carriers can't afford to ignore nagging problems in their own backyards, though. Air France has suffered two pilots' strikes already this year, costing more than $13 million. BA's heavy reliance on high-margin passengers in first and business class, who account for 40% of revenues, has made it especially vulnerable as the Iraq war and SARS have sharply curtailed business travel. BA says that travel by its high-margin passengers in March was down 23.8% from the previous month, following a 14.3% decline in February. And even if Lufthansa saves $20 million on reduced working hours, that won't offset its losses related to SARS, which analysts at Citigroup estimate could top $200 million this year.

The low-cost carriers are another threat. On its short-haul domestic flights, Lufthansa faces intense competition not only from Ryanair and easyJet but also from more than a half-dozen homegrown players. It's a tough challenge: Ryanair's costs per available seat kilometer, a standard benchmark, are less than half Lufthansa's. But, says CEO Weber, "there are opportunities for a good airline in such a crisis. You can put more distance between yourself and your rivals." Doesn't sound like Lufthansa plans to ease up on the throttle anytime soon.

By Carol Matlack in Paris, with Joseph Weber in Chicago and Wendy Zellner in Dallas

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