MIAMI — Earlier this month, European giant Lufthansa and Etihad held a joint news conference that on the surface seemed cosmetic. While rumors abounded that the two carriers were about to build a massive partnership, perhaps deepening ties via Etihad investments airberlin or Alitalia, or perhaps even merging (at least to the degree allowed by European and German law).

Anticipation built up to the joint press conference on February 1, 2017, but in the end, the expansion of the “partnership” between was mundane at best.

In addition to a previously announced codesharing deal for Etihad flights to Germany and Lufthansa flights to South America, the airlines co-located at Lufthansa’s hubs in Germany (Terminal 1 in Frankfurt and Terminal 2 in Munich), signed a memorandum of understanding (MoU) for joint aircraft maintenance, and signed a $100 million catering agreement for Lufthansa’s LSG Sky Chefs to provide catering services for Etihad at 16 stations for a period of four years.

More broadly, the deal is still indicative of deeper (if ever so slightly) commercial ties between Europe’s second largest airline group and the smallest of the four primary Middle Eastern carriers (Etihad, Qatar Airways, Turkish Airlines, and Emirates). 

While the more extravagant predictions about a partnership between the two airlines did not materialize, such a move, when combined with the exit of Etihad CEO James Hogan in the back half of 2017 would be at least a tacit admission that Etihad’s commercial strategy needs a rethink. Pivoting to deeper ties with Lufthansa would be a way of achieving exactly that, following in the footsteps of rival Qatar Airways, who owns 20.01% of British Airways parent International Airlines Group (Europe’s third largest airline group) after capitalizing on the brief stock market turmoil following Brexit in 2016.

While the finances of the Middle Eastern carriers have certainly taken a hit in the past 2-3 years, they are still backed by exceedingly wealthy governments (Abu Dhabi’s sovereign wealth funds are still worth more than $1.02 trillion despite the decline in the price of oil) who are eager to support the flag carrier. 

Meanwhile on Lufthansa’s side, any sort of equity infusion at a premium to the current market price would be a boon for shareholders that have seen nearly 35% of their shareholding value wiped out since 2014 in the face of low cost competition within Europe, aggressive battles with the Middle East Big Three Plus One (Etihad, Emirates, Turkish Airlines, and Qatar Airways or the MEB3 + 1), recalcitrant labor groups orchestrating a series of strikes, and general economic malaise in Europe. Offering a 30-40% premium on the current share price would likely be welcomed with open arms by Lufthansa’s shareholders, and an investment would give Etihad some buffer (and a politically well-connected ally) against any sort of competitive restriction on access to European markets for Middle Eastern airlines.

Fundamentally, Lufthansa is an undervalued asset. In terms of revenue Luthansa is roughly on par with United Airlines (far from a runaway financial success), yet the latter airline is worth nearly four times as much as Lufthansa. 

Etihad’s partnership strategy has been a mixed bag at best

Indeed there is certainly a commercial and strategic logic to an Etihad tie up with Lufthansa whether via investment or otherwise. But the same is not uniformly true of Etihad’s previous airline investments. In fact Etihad’s previous airline investments, grouped under the so-called equity alliance of Etihad Airways Partners.

Before assessing the higher order principles at stake here, it’s probably worth briefly recapping the execution of that strategy since it began in December 2011.

Beginning in 2011, Etihad acquired stakes in Air Berlin (currently 29.21%), Air Serbia (49%), Air Seychelles (40%), Alitalia (49%), Darwin Airline (34%), Jet Airways (24%), Virgin Australia (24.2%), and Aer Lingus (2.987%). Of these, the Air Berlin and Alitalia acquisitions have been blatant failures (more on this below). Air Seychelles and Darwin Airline are inconsequential, as the Seychelles isn’t a particularly strategic feed market for Etihad (or a big market period) and the idea that Etihad Regional would provide feed on the opposite end of Etihad’s flights to and from Geneva was an idea doomed from the start.

For the sake of expediency we’ll avoid ripping too deeply into the basing of a few of Etihad Regional’s aircraft to fly point to point vacation routes from Lugano, an airport with service to a grand total of two destinations outside of Etihad’s operation and an airport that is just 40 miles north of Milan-Malpensa, one of Europe’s busier hubs. 

Aer Lingus has been successful in the period of Etihad’s ownership stake but said stake is so minor that its hard to attribute any of that to Etihad’s whopping 3% share. Virgin Australia hasn’t necessarily been a financial basket case by any means, but nor has it been a runaway success during the period. Undoubtedly Virgin Australia’s domestic routes help some in feed and connectivity for Etihad’s four Australian routes, but only to a certain degree. But since Australia is an open skies market by and large with much of the world, unlike with Jet Airways, there isn’t a ton of strategic value in terms of market access. 

Jet Airways probably qualifies as a success at this point, with the carrier turning its first profit in eight years for the fiscal year ending March 2016 under the partial ownership of Etihad. Moreover, the strategic value of access to the Indian market for a UAE carrier (via Indian carrier rights) is so immense that the acquisition is probably defensible even if it were dilutive to Etihad’s meager (earnings). Air Serbia is also probably a success, having turned a small profit the last couple of years.

The margins are nothing spectacular (around 1%) but three state years of profit for what was a basket case of a state run airline in the form of Jat Airways is at the very least a successful turnaround story. So the results of Etihad’s strategy haven’t been uniformly negative by any means – in fact they are the very definition of a mixed bag if looked at as a basket of seven discrete outcomes. 

Listen to the Airways Podcast Deep Dive episode discussing Etihad’s partnership strategy.

Etihad was predestined to crash and burn with Air Berlin and Alitalia

The problem is that the failures at Alitalia and Air Berlin have been so overwhelming that they have more than offset any marginal payoff from the overall track record. There was a certain brash arrogance and admirable if foolhardy swagger to Etihad’s belief that it could just walk in and turn around these two carriers with a mixture of cash and strategy improvements. That logic is surprisingly not indefensible.

Even with Etihad’s less than optimal strategy for its core airline, it’s at least believable that they would be strategically superior to the incompetent management teams at Alitalia and Air Berlin who had exacerbated those carrier’s natural disadvantages. And the two airlines undoubtedly could use the cash infusion.

The problem is that fundamentally for a turnaround of a failing airline to succeed, the new management team has to be able to make the best commercial decisions regardless for the airline free of political interference. Moreover, it requires the ability to make hard choices and cutbacks to an airlines operating model and labor compensation.

The problem is that fundamentally, Alitalia was never going to be free of interference from the Italian government and unionized employees at both airlines were never going to accept the kind of restructuring that would actually give each airline a chance. Its a tale as old as time at state owned airlines (Alitalia) or European ones – unions and politics sank the ship.

This diagnosis is not meant to absolve Etihad of responsibility entirely (ultimately they threw good money after bad), but rather to contextualize why they were doomed to failure from the start.

Taking a step back from the twin European pillars of financial woe, more broadly Etihad’s investment strategy is a textbook example of getting inorganic growth wrong. Particularly when laws prevent a full merger (which has its own toolkit for assessing merits and costs), there are really only two cases for partial investments in foreign carriers via minority shareholdings.

The first is a case where the airline has some sort of strategic asset value whether that’s slots at London Heathrow, or route authorities between the UAE and India. The second is when that asset is so undervalued relative to the market it is in (on a long run basis) that even modest strategic improvements (no one should expect to hit a strategy home run) have a payoff. The ideal investment case is some combination of both (think Delta’s investments in Virgin Atlantic or Aeromexico).

For Etihad, only Jet Airways really fits that bill (maybe Air Serbia if you stretch the undervalued definition a bit). 

Etihad not immune to the problems of the MEB3 at large but has it worst 

What makes the present situation particularly alarming for Etihad is that the unique challenges of its partnership strategy are layered onto an already worsening environment for the MEB3. We will be exploring that topic in more detail in a follow up piece on the broader MEB3 + 1 in the coming days, but suffice to say that Etihad is by no means insulated from the revenue pressures of its peer airlines.

Etihad is by far the poorest performing MEB3 carrier, with profit margins around 1% as compared to ~4.5% for Qatar Airways, and ~10% for Emirates. Emirates is in a class of its own because Dubai has evolved into the premier trade and financial center for the Islamic World and to an extent for Muslim South Asia, which gives Emirates a different degree and caliber of origin and destination (O&D) traffic to fill its planes with. But there’s no reason, short of poor management and strategy, that Etihad should be underperforming Qatar Airways.

In fact with Etihad’s much greater access to India, it should arguably be outperforming Qatar Airways, and the fact that it isn’t likely contributed to James Hogan’s departure.