Tuesday, May 03, 2005

Lufthansa takes over Swiss: Operation successful, patient dead?

On March 22, 2005, the German carrier Lufthansa AG and Swiss Air Lines AG agreed on a complete take-over of Swiss by Lufthansa (see here and here ). Discussions have been going on for a little more than one and half years and the move was widely expected. The transaction is fairly complicated as Swiss is owned by public institutions, including the Swiss Government and a number of cantons, large private shareholders, such as UBS and Credit Suisse, and a small number of public shareholders. While the public shareholders will be bought out in a public tender offer, the public institutions and the large private shareholders will receive an out-performance option in exchange for their shares, the payout of which will depend on the performance of Lufthansa’s share price compared with competitors’ shares.
The executives of both Lufthansa and Swiss are psyched about the merger and see clear benefits for their customers. More destinations, better connections, comprehensive frequent-flyer programs and mutual lounge access enhance the attractiveness of both companies, they say. Swiss will keep its own brand appearance, continue to develop its strengths, und expand its geographical advantage on the Swiss market. This includes a demand-driven international network of routes as well as an intercontinental hub at its base in Zurich, which is to be developed on an equitable basis with the Lufthansa hubs in Frankfurt and Munich. To understand whether this merger makes sense and whether the rather challenging goals can be achieved, we have to dive into Swiss' history.
Swiss emerged out of the former Swissair which went bankrupt in a spectacular fashion in the fall 2001 (for events before that date see also here). It culminated in opaque events around a working capital bridge financing that allegedly was not made available by Swiss banks who, in turn, accused the Swissair executives of poor cash management. Later investigations have not proven any of these allegations, though. Fact is, Swissair ran out of cash and had to ground its whole fleet at Zurich Airport. As a consequence of these highly emotional events, the Swiss Government, cantonal governments and other politicians felt the need to step in and participate in the restructuring. The rescue plan was structured around one of Swissair's subsidiaries, its short distance carrier, Crossair. In a series of complex transactions, the airline business was transferred to Crossair, while all non-airline business was subsequently sold out to third party buyers. Crossair was renamed Swiss International Air Lines Ltd., ring fenced and financed by the Swiss Government, some, but not all, cantons and large private shareholders, such as banks, insurance companies and Swiss entrepreneurs.
Since its early days, Swiss has been struggling. While the management blamed the overall market downturn following the events of September 11, 2001, the lack of a clear strategy is equally to blame. Swiss continued to operate a large long haul fleet and was only slowly able to control its costs. Conflicts with the pilots association dragged on and competitors' refused to let Swiss into one of the precious alliances. In addition, Swiss' hub, Zurich Airport, faced tremendous pressure from Germany because South German villagers were not willing to bear the landing procedure any longer and a new treaty put the airport at a disadvantage to operate efficiently.
No wonder, therefore, that most reactions to the takeover of Swiss by Lufthansa are overwhelmingly positive (We apologize for the German sources, but nothing in English is accessible without signing up: 1; 2; 3).
One seems to have got rid of a problem. We believe otherwise: operation successful, patient dead.
First, the takeover could be seen as yet another proof for the failure of governmental market intervention. However, governments mess around with subsidies for the airline industry all around the world. So, while a purist might argue there should be no intervention at all, fact is everybody does it (including Boeing and its lucrative military contracts). But, when you do it, you have to do it right. If the government bails out half way down the road, it capitulates before the battle is over. In addition, this government will have a hard time justifying the next intervention. We believe the Swiss public institutions should not have participated financially in the restructuring of Swissair. But once they did, they should have stuck to it until Swiss would have flown on its own again.
Second, we don't see the strategy behind the move, neither for Lufthansa nor for Swiss. The burden of downsizing and cost cutting remains the same. Due to its disputed landing procedure, Zurich Airport as a hub is likely to fail and will most probably have to accept its status as a regional airport, bringing passengers to Frankfurt and Munich. Competitive pressure from cheap carriers such as Ryanair or Air Berlin will not allow air fares to rise significantly, depriving Lufthansa / Swiss of the ability to exploit profits on routes between Germany and Switzerland.
Finally, the high reputation and its world renowned service level is Swiss' most valuable asset. We fear the service level of Swiss to fall to Lufthansa's, which is not at the same, something every business traveler readily confirms. Only if Swiss is managed as a stand-alone company targeting the premium customers with premium service, Swiss could rise to new heights again. This requires airline management to completely overhaul their view on how to segment the market. Swiss would not be a national airline anymore, but a premium airline targeting the top segment of air travelers. The stand-alone strategy would, however, only be viable as part of one of the big alliances, which Swiss proved unsuccessful to get into. In this regard, Swiss can be glad they found access to Star Alliance through Lufthansa. So, in the end, the patient might still have a chance to live if the new doctors change the operation.
Oliver Banz / Amit Chandra

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