As expected, the German government is determined to bail out the company behind the country’s flag carrier, Deutsche Lufthansa AG (OTCQX:DLAKF; OTCQX:DLAKY). A few weeks ago, I suggested that investors should wait for the details to be clear. Now, that seems to be the case. All in all, I believe that the terms are rather favorable, albeit not perfect, for Lufthansa. The only major problem I see with the deal is that Lufthansa might lose slots at two of its most important hubs due to requirements from the European Commission. Below, I will take a closer look at the agreement and explain my thesis in more detail.
Lufthansa Airbus A350; source: Deutsche Lufthansa AG
The Financial Details
Overall, Lufthansa will receive about €9 billion under the terms of the agreement. Via its Wirtschaftsstabilisierungsfonds (“Economic Stabilization Fund”; WSF), the government would make a direct equity investment of nominal €300 million, equaling a 20 percent stake. Additionally, there will be a silent participation of €5.7 billion. Furthermore, it would reserve an option to increase its ownership to 25 percent and one share in order to be able to block a takeover. It can convert €1 billion of the silent participation into common stock for that purpose or in order to prevent dilution. Lufthansa will pay an interest rate of 4 percent, which will later increase to 9.5 percent. The last third of the package consists of a government-backed €3 billion credit at (relatively) favorable conditions.
There are of course some strings attached, but overall, the German government shows remarkable restraint in its demands. First of all, Lufthansa has to make no job guarantees. From my point of view, this is one of the most important aspects. Global air travel will inevitably take longer to recover than most other industries. That is not only due to less tourism. Maybe even more importantly, there is the realistic risk of less business travel. A recession will only be one reason. Another is that, across all industries, businesses are likely to realize that they could save time, money, and, in many cases, stress by utilizing the likes of Zoom Video Communications Inc.’s (ZM) namesake software or Cisco Systems Inc.’s (CSCO) WebEx instead of having people fly to attend meetings or conferences in person. So, all airlines will have to readjust in size in order to regain profitability. Inevitably, that requires cuts to fleet and workforce. Like it or not, the industry will become more cutthroat going forward. Much of that will inevitably come at the expense of employees. Inability to take the necessary measures fast and without hesitation would be a huge weakness. Since Lufthansa already treats its employees rather generous compared with competitors, it is of paramount importance for the company not to be limited in its options by any additional restrictions.
For similar reasons, it is a positive sign from my point of view that the German government has given in on former plans to force Lufthansa to take delivery of all its 150 ordered Airbus SE (OTCPK:EADSF; OTCPK:EADSY) airplanes. Post pandemic, the company will simply not need all those aircraft. Forcing them to take delivery of them anyway might save jobs, both at Lufthansa itself and at Airbus, but it would have created a giant obstacle when it comes to a potential return to profitability.
Maybe most importantly, the government refrains from imposing environmentally motivated restrictions on the company. Unlike Air France which has to cease operations on certain domestic routes in a push to strengthen railway travel, Lufthansa will remain free in its operational decisions. There are sustainability targets, but those are connected to fleet renewal. But that would have been necessary anyway. At the end of the day, that might be beneficial in the long run. More efficient aircraft emit less CO2 due to lower fuel consumption. And lower fuel consumption automatically means lower fuel cost. So, in this regard, what is good for the environment is good for the shareholders too.
As the largest shareholder, the government will appoint two members of the supervisory board. However, under the terms of the agreement, the seats are to be filled with independent experts, not politicians or civil servants. That clearly reduces the risk of social, political or environmental considerations interfering with the company’s best interest. Unlike politicians, independent experts are not likely to side with employee representatives in order to push the interest of the workforce either. After all, being an independent expert is more or less the profile that a member should have anyway.
There are some other concessions that Lufthansa has to make, but I believe they are rather acceptable. For example, the company may no longer use tax heavens. Lufthansa agreeing not to employ some means of tax optimization should not be that big of a problem. Sure, every cent of avoided taxation is a good thing. Nonetheless, I doubt that the overall effect will be too dramatic. Notably, even outside of tax heavens, there are ways to optimize the tax strategy, including within European countries and certain US states (looking at you, Delaware). From an investor’s point of view, it is also not a big deal that senior management will have to accept pay cuts and will not receive bonuses as long as the government is invested. On the contrary, strictly speaking, that does in fact save money – albeit in insignificant quantities.
Of more significance for investors is probably that the company may not pay any dividends as long as the government – which in turn would still be paid the interest on the silent participations – is a shareholder. However, while that situation is certainly not ideal, I believe that a dividend would not have been realistic anyway for the next two to three years. Even if the company should become more profitable than expected faster than expected, it would make much more sense to pay pack the silent participations as soon as possible, thus making use of the lower interest rates during the first years. Therefore, the government-imposed dividend restrictions are less meaningful in practice than they may appear to be. Also, there is a clear exit plan. The target is for the government to sell its equity stake until 2023, earlier than what European legislation would mandate (max. 6 years). Provided the silent participation is relayed in full, the WSF will sell its stake on or before December 31st of that year at the market price.
The Valuation Issue
Although the German government clearly shows restraint in terms of the demanded concessions, I believe that there are certainly investors who still have major objections. For example, the right to appoint board members is not commonly granted to even large shareholders under German corporate law. Absent statutory provisions, the general meeting instead elects the shareholder representatives on the supervisory board by majority vote. The case could also be made that a blocking minority would not have been necessary in order to prevent a (hostile) takeover as there are already other legal instruments available to the government in the case of an airline.
However, one has to keep in mind that we are looking at a considerable investment here. Admittedly, if purely looking at the common equity, the government is buying at a steep discount (subscription price per share: €2.56; compared with a market price of currently more than €9 per share). However, one has to take into account the bigger picture in order to be fair. For €9 billion, one could have bought the company twice and still have a ten-figure sum left. No private investor would have invested that kind of money for a mere 20 to 25 percent ownership. So, all in all, given the circumstances and taking into account Lufthansa’s current valuation, the package is not unattractive for investors, who may otherwise be diluted massively, if not entirely wiped out, in the case of a bankruptcy.
Brussels Is The Bigger Problem
The problem in the case of Lufthansa is not in Berlin but in Brussels: The biggest caveat is the European Commission’s demand for the transfer of slots on the Frankfurt and Munich airports to competitors. Under the rules of the Handelsgesetzbuch (the German commercial code), €4.7 billion of the silent participation would be treated as equity. So, legally speaking, we are looking at about €5 billion equity injection. Hence, Brussels is inclined to treat Lufthansa different than, for example, Air France-KLM SA (OTCPK:AFRAF;OTCPK:AFLYY) which is supported by the French government with €7 billion of loans and credit guarantees.
Lufthansa has to yield up to 24 slots for four airplanes to new competitors at the respective airports. If no new competitor makes use of this option within one and a half years, it will be extended to existing competitors. The slots will be allocated in a bidding process. One important detail is that the only European competitors which did not receive state recapitalization are eligible. That may narrow the field of potential bidders substantially.
However, the problem stems not so much from competitors gaining, but from Lufthansa losing the slots in question. It is important for Lufthansa to offer as broad a network of connecting flights as possible. The airline’s business model is centered around its hubs, and Frankfurt and Munich are the most important ones, alongside Zurich (for Swiss International).
Lufthansa’s executive management has accepted the terms. The supervisory board, on the other hand, saw itself unable to approve the stabilization package and has postponed a decision. German officials, including chancellor Angela Merkel and the Hessian and Bavarian prime ministers, Volker Bouffier and Markus Söder, have positioned themselves against the Commission’s demands as well. Same goes for the powerful Verdi trade union.
Nonetheless, I doubt that, even with political support at home, Lufthansa will be able to negotiate a better deal. The European Commission should not be underestimated. Especially, the EU Commissioner For Competition, Margrethe Vestager, has proven her effectiveness and determination many times. The European law is on Brussels’ side. And, although it sounds counterintuitive at first, neither does it help that the Commission is led by a German, Ursula von der Leyen, chancellor Merkel’s former minister of defense. She has to be especially careful not to appear favoring her native country. Furthermore, there are also competitors which might take legal action. Especially Ryanair Holdings plc (OTCPK:RYAOF; RYAAY) has been highly critical, claiming that massive government-backed investment would “massively distort competition” and threatening to appeal that decision.
All in all, I believe that the conditions of the bailout package are rather favorable for Lufthansa. There are some caveats like the dividend freeze and – most importantly – the likely loss of important slots at the Frankfurt and Munich airports. But given the circumstances, it is the best option available. In an environment challenging for the entire aviation sector, Lufthansa might even fortify its relative position.
But it is not yet a done deal. The agreement requires the approval of the supervisory board as well as the general meeting. Until that happens, there is still the chance of Lufthansa going into bankruptcy instead. And the clock is certainly ticking. Especially approval by the general meeting is not yet a done deal. Much will depend on the company’s largest shareholder, Heinz Hermann Thiele, the majority owner of Knorr-Bremse AG (OTCPK:KNBHF) and controlling shareholder of Vossloh AG (OTC:VOSSF;OTCPK:VOSSY), who bought a ten percent stake back in March. I therefore remain neutral in my view of the stock, until the deal has Brussels’ clearance as well as the approval of Lufthansa’s supervisory board.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Disclaimer: All research contained in this article was done with the utmost care. However, I cannot guarantee accuracy. Every reader is advised to conduct his or her own due diligence and research.
Kindly note that this article was written on May 31st. There may be more recent developments by the time of publication.