Thursday 15 November 2018

Aer Lingus warns it faces turbulent times as low-cost Norwegian and Ryanair threaten its market share

Aer Lingus threatens to outsource work as it says it can't afford a €107m rise for staff and already pays more than rivals

'The document outlines how Aer Lingus’s transatlantic ambitions face a major threat from Norwegian, the newest entrant to Ireland’s transatlantic market.'
'The document outlines how Aer Lingus’s transatlantic ambitions face a major threat from Norwegian, the newest entrant to Ireland’s transatlantic market.'

Fearghal O'Connor

The honeymoon period is over. That is the stark message from a confidential document prepared by Aer Lingus management, outlining the challenges the airline faces.

Since Willie Walsh's IAG bought Aer Lingus in 2015 all of the vibes have been positive. News of profit growth, new routes and the emerging transatlantic hub at Dublin Airport has given the impression that, if anything, Willie Walsh got a bargain deal from the Government.

But an extraordinary 49-page submission to the Labour Court, seen by this newspaper, outlines in stark terms just why the airline's management believes that it cannot give in to a huge pay claim from trade unions.

The document outlines how Aer Lingus's transatlantic ambitions face a major threat from Norwegian, the newest entrant to Ireland's transatlantic market.

It also brands its short-haul operation as "structurally unsustainable", admitting it has been negatively impacted by Ryanair's improved customer focus.

And, most ominously, the document warns that IAG would pull back funding if the pay increases were to go through and that outsourcing could become a reality.

Contamination effect

Trade unions are seeking a 5pc pay increase each year for three years, as well as a profit share and the restoration of increments foregone during the recession. The total cost of the claim over three years - if the profit share was just 1pc - could be as high as €107m, said the Labour Court submission. The claim, it said, would mean a 29pc increase on the pay bill for the staff in question.

"This is for one section of our workforce and we must give full consideration to the contamination effect for non-operational staff and our pilot population if we applied the same 29pc across the board…"

The pay hike, if granted, would give competitors a significant cost advantage, reduce transatlantic growth and restrict Dublin Airport's "opportunity to develop as a gateway to the North Atlantic".

Aer Lingus is already "off-market" with regards to its cost base, and much of this relates to employee costs, it said.

"There is simply nowhere to go if off-market pay, terms and conditions are maintained. Market share will be conceded to Ryanair, Norwegian and other value carriers, and Aer Lingus will be forced to contract its business," it warned.

The document cites the example of cabin service managers in Aer Lingus who earn €63,000, 38pc more than in Easyjet. Aer Lingus cabin crew on almost €38,000 earn 31pc more than their Easyjet counterparts, it said.

Structural Challenges

According to the document Aer Lingus faces "two significant structural challenges".

The first is the launch of Norwegian's services from Dublin, Cork and Shannon to the US "utilising a cost base significantly lower than Aer Lingus". The second key challenge is the need for Aer Lingus to return its short-haul business "to long-term sustainable profitability which justifies its return on invested capital".

Given that the document is a Labour Court submission in which management is arguing that it is not in a position to grant what it sees as overly generous pay hikes, it is perhaps not surprising that the sentiment expressed is one of negativity. No doubt a 49-page document prepared for a different audience - say an investor roadshow - would accentuate many more of the positives. But the Labour Court submission is blunt in its assessment of the airline's financial performance: the business "remains susceptible to external shocks" and must move away from "the historical 'boom and bust' scenario through structural change".

Aer Lingus has been "a marginally profitable company during the 10 years to 2015, having failed to deliver sustainable profits during that period. The business exists in a structurally marginal state and needs to continue to reduce its cost base if it is to be sustainable in the future".

The 2016 financial year was "the first time in the last 20 years that results will get close to Aer Lingus's main competitors and what credit agencies would consider 'normal'."

After years when staff accepted a series of pay freezes, high profits have been a key reason cited by the company's trade union group for the large pay claim. Profits increased by €109m from €124m in 2015 to €233m 2016.

But, according to the submission, this strong recent performance is a fragile thing. Aer Lingus's employee cost base is unsustainable with pay on average 20pc to 50pc higher than market rates and the airline is "at a competitive cost disadvantage against its main rivals such as Ryanair on short-haul services and the new breed of low-cost long-haul value carriers".

"The continued un-competitiveness of the airline's operational cost base is real, and will hinder, or if allowed to deteriorate further, potentially reverse growth plans," said the document.

The main drivers of profitability in 2016 were a low fuel price, low interest rates and "holidays" across debt repayments.

A major advantage for the airline in recent years has been the fact that it chose not to replace 14 older short-haul Airbus A320 and eight older long-haul A330 aircraft that it owns and which have been written down heavily resulting in low annual depreciation costs.

But that advantage is now turning to disadvantage. Currently the airline has 52 aircraft including four leased 757s. It plans to increase the fleet to 61 aircraft, amounting to a required investment well in excess of €1bn.

The risk of fuel price increase is also "significant and material in terms of Aer Lingus profitability". "With continued Middle East unrest, Brexit and the new Trump administration, many believe that fuel increases are likely."

If fuel were to increase by 30pc from today's levels - still relatively low in historical terms - Aer Lingus's cost base would rise between $100m and $120m, it said.

Growing competition

Competitive pressure and economic uncertainty is increasing both on short haul and long haul, it said. Ryanair overlaps with Aer Lingus on 86pc of the short-haul market "and continues to grow market share ex-Dublin at the expense of Aer Lingus".

On the long-haul transatlantic market, where Aer Lingus has focused much of its recent expansion, it faces competition on 82pc of routes, said the document. The real problem is the nature of the competition: Aer Lingus, it said, is up against "both low-cost emerging value carriers and legacy US carriers, who have had the benefit of significant cost base restructuring through Chapter 11".

The Aer Lingus document warns that the growth in capacity in "the value carrier market" from carriers with similar models to Aer Lingus, such as Wow, Icelandair, Westjet, Air Transat, Rouge and Norwegian, "is far exceeding overall market growth trends".

The level of competition faced by Aer Lingus means "there is little or no ability to pass on additional and excess cost through fare increases", it said. Aer Lingus is "a value carrier and its primary weapon is price" but "competitors with lower cost bases will continue to aggressively develop their positions across our network".

Indeed, the "very success that Aer Lingus has experienced on the transatlantic market will, in itself, act as a 'magnet' to competitors who will look to come on the same routes as Aer Lingus", it said.

Norwegian threat

The document highlights in particular the transformative growth ambitions of Norwegian" with its plans to scale up its wide bodyfleet to 32 by 2018: "Norwegian will be a key competitor for Aer Lingus in future."

The competitive environment on the short-haul market is also to "get more difficult" with Ryanair planning a 14.5pc increase in flights from Dublin for 2017, compared to Aer Lingus's planned 2.7pc growth.

"Furthermore, Ryanair is targeting its growth on primary airports as well as secondary airports. This means that Aer Lingus faces a greater proportion of direct 'same airport to same airport' competition. This is significant to Aer Lingus as the Aer Lingus cost per ASK [available seat kilometres] excluding fuel is 5.16 euro cents as compared to Ryanair at 2.1 euro cents, so Ryanair's cost base is less than half the level of Aer Lingus," said the document.

The document also warns about the success of Ryanair's 'Always Getting Better' programme, saying that the heavy investment in customer focus has "directly impacted Aer Lingus". Aer Lingus's 'sentiment tracker' between April 2014 and November 2016 found that the number of passengers stating that 'Ryanair is better than Aer Lingus' had grown from 10pc to 15pc.

"This means that the Ryanair campaign is proving successful in changing perceptions of its brand but also putting more pressure on Aer Lingus in terms of justifying the premium it charges," it said.

Just what Michael O'Leary's heavily-criticised appearance on RTE's Liveline last week has done for these perceptions would, of course, be interesting to track.

IAG resources

The document also dispels any notions that trade unions and staff might have had that London IAG is the aviation equivalent of a sugar daddy for its new Irish subsidiary. It must compete for resources against other IAG airlines such as British Airways, Iberia and Vueling.

As "a rational parent company", IAG deploys its capital resources to the airline that can generate the highest return on invested capital (ROIC), it said.

"Unreasonable pay requests risk damaging Aer Lingus's ability to deliver acceptable profits and cash generation and therefore threaten to reduce IAG's willingness to allocate cash resources to Aer Lingus and support future growth," it said.

And the airline has a stark warning for its staff. The short-haul business, where the vast majority of staff are deployed and which accounts for 54pc of passenger revenue, is "structurally unsustainable due the higher cost of employment and lower productivity levels when compared with direct and genre competitors".

This has meant that the short-haul operation has "delivered cumulative losses between 2008 and 2015 and does not pass the threshold of our required ROIC return to justify replacement investment."

Cost-cutting and productivity programmes were undertaken across the ground and cabin workforces in 2016 but need to now be sustained in terms of pay, it said.

In the past threats of outsourcing have hung over airport staff. The Labour Court submission makes it clear that the threat has not gone away.

"While it is our preference to continue with a direct-resource model, if balance between pay movement and productivity cannot be achieved going forward, we will have no choice but to revisit the current resourcing model," it said.

Elsewhere, the document outlines how the airline's ground operation is carrying a "legacy cost from having an in-house operational model that is different from the outsourced model that many global airlines now adopt".

For example, it said, Aer Lingus has a range of "legacy" terms and conditions "typically not present in the employee agreements at a third-party handling agent and are contributing to significantly higher unit costs".

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