Model Planes

Lufthansa CFO Stephan Gemkow on how the German airline's recent takeover of SWISS charts new territory.
Eila RanaJuly 27, 2007

Stephan Gemkow, CFO of Lufthansa, has pulled off a first in the European airline industry — the €19.8 billion German flag carrier has become the first airline to own another nation’s flag carrier outright. The full acquisition of Switzerland’s €2.5 billion SWISS is effective from July 1st 2007.

An airline’s right to fly from its home country to another country is governed by strict rules, which dictate that the airline must be majority owned by a domestic shareholder. But Lufthansa’s successful renegotiation of SWISS’ traffic rights on a country-by-country basis — the negotiations were led by the Swiss government — means SWISS retains its routes as Switzerland’s flag carrier, despite being German-owned. Gemkow says the merger will boost the competitiveness and profitability of both airlines.

His CEO, Wolfgang Mayrhuber, says the SWISS acquisition will serve as a model for future M&A in the sector. CFOs of other European flag carriers must certainly hope so. They are under pressure to find new ways to deal with pan-European budget carriers that are stepping up competition in the sector. Consolidation is one option but complex rules governing ownership and traffic rights have made that difficult — until now.

On the day that the SWISS takeover was completed, Gemkow discussed the deal with Eila Rana, who writes for CFO.com’s sister publication CFO Europe.

What was the rationale behind the takeover approach for SWISS?

By bundling the forces, we wanted to strengthen the competitiveness and improve the profitability of the two airlines. We were sure that the integration would bring clear benefits for our customers: more destinations, better connections, comprehensive frequent-flyer programmes and mutual lounges. As a result, this would then enhance the attractiveness of our group and this definitely has become true.

What sort of financial health was SWISS in at the time of your first approach?

Lufthansa initially approached SWISS in 2003. At that time, SWISS was in a bad financial situation. The deal did not take place due to the fact that the time was not ripe to put ownership into foreign hands.

The second approach took place at the beginning 2005. SWISS had already unveiled a corporate restructuring programme. So when the takeover was announced, SWISS was pursuing various performance-enhancing improvements, such as negotiating new collective labour agreements with its employee groups, renegotiating terms with its principal suppliers, streamlining its fleet and generally establishing a competitive cost structure. In fact they had already been doing better when it came to the deal.

What were the main challenges that SWISS, as a mid-tier national carrier, presented Lufthansa with and how is the company tackling them?

Because SWISS had already done a lot of its homework, there were no real challenges left. Just the opposite. We found several examples where the SWISS operation was more efficient than ours. We have had the chance to study these processes and apply the lessons learned at Lufthansa. SWISS is on course. It now has to maintain that course through its present growth phase. This is essential as the competition will be even tougher in the future.

Have you had to implement any changes to boost the performance of SWISS?

As SWISS had already entered the restructuring process at the time we approached them, there were no significant operational changes we had to implement. SWISS itself, driven by a focused management team, is well on its way, as is the integration process. The success is already visible in the group results. Last year, the partnership’s overall synergies totalled more than €200m and were significantly higher than the amount originally forecast.

What were the anti-trust issues that arose from the proposed takeover?

To secure the approval of the European Commission, Lufthansa has to make slots available to other carriers on the routes between Frankfurt and Zurich, Munich and Zurich as well as other European and intercontinental routes. The agreed measures come into place once a new competitor wants to fly on one of the identified routes and cannot receive the necessary slots via the normal slot distribution process.

Only once has a competitor requested some of the mentioned slots. This was Air Berlin on the Frankfurt-Zurich route. In the meantime Air Berlin has ceased offering this city pair and the slots have been given back to us. An independent trustee engaged by the European Commission monitors the initially agreed measures.

What have the negotiations to secure Swiss traffic rights involved? Have there been any major obstacles in this area for you to overcome?

The acquisition of SWISS was dependent on securing its traffic rights. For this reason and due to the requirements of antitrust law, we had to conduct the acquisition in several steps. The shares of SWISS were to be held by a newly established Swiss legal entity — AirTrust AG. During a first step, Lufthansa acquired 11% of AirTrust. After receiving antitrust clearance, the share was increased to 49%. At the same time, consultations and negotiations commenced in order to secure the air traffic rights.

As air traffic rights are negotiated between countries, the negotiations were carried out by authorities [in Switzerland] and involved confirmation from the country of destination that a SWISS flight is also possible under the new shareholder structure — in this case 100% German.

The general trend in the air traffic industry is one of deregulation. Negotiating the air traffic rights took a bit longer in countries that are highly regulated [most of which are in Asia]…. We were aware from the beginning that this process would take some time. The process was conducted efficiently by the authorities in Switzerland. After intense negotiation and talks, all necessary air traffic rights have now been secured. As of July 1st, Lufthansa will take over all shares in AirTrust and therefore have full control over SWISS.

Part of the takeover agreement involves maintaining the SWISS brand. Why is this? And can you see a time when it would make sense for both carriers to operate under one brand?

It is Lufthansa’s strategy to be a “house of brands”. We believe that each airline of our group serves its own segment or an own market. Within the Lufthansa group, SWISS will keep its own brand identity, which is a measurable value in itself. We are well advised to capitalise on the strength of the brand and use it to grow and expand the SWISS operation.

How do you think the Lufthansa-SWISS deal reflects what is happening to mid-tier national carriers in the European airline industry?

Consolidation in the airline industry is necessary. The sector is continuing to change. Liberalisation — such as the newest Open Skies agreement [between the EU and US to liberalise the transatlantic air travel market] — result in an increase in competition. Business models, such as the low cost carrier concept, are penetrating the market. This all leads to a permanent erosion of yields which has to be tackled by unit cost advantages. Consequently, the pressure on mid-tier carriers will increase in the future. Having said this, the SWISS transaction stands out because of its tremendous success and will remain unique in its characteristics.

So how will Open Skies affect Lufthansa and SWISS?

The agreement gives all European and US carriers new possibilities — for example, offering new and additional flights. For the first time EU carriers can buy carriers from other, non EU-countries that have their own Open Skies treaties with the US. As Switzerland has such an agreement, Lufthansa ownership of SWISS no longer poses a problem for Swiss traffic rights. This gives Lufthansa and SWISS much needed legal certainty and new strategic options, which we are currently studying. Should there be promising opportunities we will certainly not stand still.