Hunter Or Hunted?

     The article you are about to read stems from a conversation that yours truly had with a global trading conglomerate’s top honcho at the ‘47^th St. Gallen Symposium 2017 – The Dilemma of Disruption’ (yup, qualified, made the cut and made the long trip to snowy, sexy and oh-so-lovely St. Gallen, Switzerland again... 'Global Top 20 Leader of Tomorrow’ this time around. You can read all about the first time as a ‘Global Top 100 Leader of Tomorrow’ at the ‘46^th St. Gallen Symposium 2016 – Growth: The Good, The Bad and The Ugly’ here).

     The gentleman remarked, “McKinsey isn’t really a popular name in Switzerland because thanks to it, the one company with the name ‘Swiss’ isn’t Swiss anymore.”

     But back in the day, it was. It was as Swiss as Swiss could be. Swissair was a national icon and a matter of pride to its country. It was the world’s leading airline and so strong were its financials that it was even dubbed the ‘Flying Bank’. The white cross on the red backdrop adorned the tails of Swissair’s jets and the flag of Switzerland criss–crossed the global skies. It was an airline that was the epitome of class and luxury. For several decades, it flew from strength to strength, almost unrivalled. But all that changed in the 1990s. With Switzerland not joining the EEA and the EU and with European skies liberalized, Swissair was cut off from serving the rest of Europe on its own. It needed to set up a new carrier in an EEA nation to fly into Europe. But instead of counting on its long history of success to make its own decision, it decided to turn to the suits at McKinsey for advice on how to expand in Europe, whence arose the infamous ‘Hunter Strategy’.

     McKinsey’s advice to Swissair was simple. Instead of incubating a new airline, it would be quicker to ramp up and recover market share in Europe by buying stakes in several airlines, to create an alliance of feeder and partner carriers. Swissair could take up to a 49.5% stake in a European carrier but not majority control, as EU laws cap foreign ownership in a European carrier at that level. While the law did deny it the right to consolidate a target, it did give Swissair a way back into Europe. But then again, the ‘Hunter Strategy’, fuelled by a concoction of McKinsey’s goading, its incompetence in aviation, Swissair’s exuberance and its desperation to fly the European skies again, turned the latter into a veritable predator.

     Swissair went on an acquisition spree, buying stakes in several carriers such as Air Littoral, LOT, Air Europe and some French airlines, most of which were in terrible financial health. The shopping spree didn’t stop at European shores though. Swissair even bought chunks of Turkish Airlines and South African Airways, in a bid to increase its international presence in the Middle East and Africa. Its biggest and boldest bet though was the straw that broke the camel’s back, or in this case, the snowflake that killed the chamois – the acquisition of Belgium’s near – bankrupt national carrier, Sabena. By having to pump in billions of Swiss Francs to keep its subsidiaries alive, Swissair collapsed into a string of losses in the closing years of the millennium, with Sabena being the biggest drain. While it had to resort to selling its family silver such as its lucrative catering (Gate Gourmet) and ground handling operations, its airlines continued to bleed. The crash of Swissair 111 into the Halifax Sea was the final nail in the coffin and in 2001, amidst a lacklustre demand for luxury air travel post 9/11, Swissair went bankrupt and Switzerland’s national icon was dead.

     For the following few months, the whole country was up in arms and McKinsey and UBS, the latter for having withdrawn Swissair’s lines of credit in its hour of need, were seen as the slaughterers of the national carrier. The Swiss Government too faced public ire for failing to step in to save its airline. Eventually, the Swiss Government did intervene and emergency loans kept Swissair alive, long enough for it to enter into administration, scale down, cut costs, sell assets and eventually merge with Crossair, in 2002 – 03, to form the Swiss International Airlines of today. But it was too little and too late. Three years later, Lufthansa swooped in and acquired Switzerland’s national carrier, in what was its long – standing desire to enter the premium airline space. Swiss’ fall to its mighty but inefficient and largely unpopular neighbour from across the border was surely a major blow to Swiss national pride and even today, a mention of the Swissair tragedy invariably leads to UBS' and McKinsey’s roles as the chief antagonists. Ironically, today, Swiss has the highest profit margins in the Lufthansa Group and in quite a few quarters, it is the only group airline that makes money while Lufthansa and its other arms are mired deep in the red. So much for German efficiency, as the Swiss would say.  

    

     Efficiency. It’s by far the most important word in the wafer – thin margin airline business, where there is no room for error, both in the skies and on the ground. The global airline industry is abound with flawed strategies and acquisitions gone awry. Other airlines have replicated ‘Hunter’ strategies of their own and most have gone into a tailspin. Lufthansa itself is more or less floundering with its multiple acquisitions – Swiss, Austrian and Brussels Airlines. British Airways bought Iberia, British Midland International, Vueling and Aer Lingus with mixed results. But there’s one airline that made the biggest and boldest moves in recent years, in a bid to capture passenger traffic and create feeder airlines to fuel its own growth. To its credit, its strategy seemed to be a success at the outset. It acquired a huge fleet of around 700 aircraft, all at the cost of a few wide-bodied jets. After all, when your backer heads one of the richest economies in the world and writes you a blank cheque to make your airline the biggest and the best, you can very well afford to.

     Etihad is the latest example of an adopter of a once – genius strategy that spiralled out of control. A strategy that was aimed at chasing global dominance but one that ended up blowing up billions of Dirhams. Long – haul travel had changed dramatically, with traffic moving away from London Heathrow and Paris Charles de Gaulle to the Middle East, on both eastward and westward routes. Etihad though was late to the party. Two decades late, to be precise. While Emirates and Qatar Airways had largely grown organically and had become the biggest beneficiaries of the rerouting of global passenger traffic, Etihad needed to catch up with its next – door neighbours and make up for both lost time and lost market share.

     Etihad’s expansion strategy was simple – Acquire, Change Management, Restructure, Turnaround, Repeat. Thus far, it had worked wonders and given it a global feeder network to route through its base at Abu Dhabi International. And of course, Etihad had followed the same strategy in several markets with all its engines at full power and managed to gain a large chunk of passenger traffic in Asia, Africa, Australia and Europe, with its ‘Etihad Airways Partners’ network. By 2013, it had 40% in Air Seychelles, 49% each in Air Serbia and NIKI, 24% in Jet Airways and minority stakes in Air Berlin, Aer Lingus and Virgin Australia, each of which gave it some board seats and management control. In a short time, Etihad managed to fly Air Seychelles, Air Serbia, Virgin Australia and Jet Airways back to profitability and it was already on the prowl for its next target.

     However, the trio of Etihad Regional, Air Berlin, Aer Lingus and Air Serbia still gave Etihad a limited presence in Europe. It needed a big acquisition to capture the European market and challenge Emirates, which had already established a dominant presence on the Middle East – Europe – Americas routes. Its own ‘Hunter’ strategy meant looking for a new target and soon enough, it found one that had a wide network, which was a large player and more importantly, an airline that was priced at cents on the Euro. That next acquisition, however, was the stage at which the seemingly invincible Arab giant flew into some serious headwinds and nearly fell out of the skies.

     Europe’s aviation landscape has changed dramatically over the past 3 decades. Today, the skies are no longer the preserve of national carriers, passenger numbers have exploded, low-cost carriers have aggressively grabbed market share and stodgy, inefficient airlines have crash-landed into bankruptcy. Looking back at the industry then and looking at the same industry now, there has indeed been a remarkable transformation. Back then, the skies were the realm of national carriers but today, both national and private carriers compete with foreign airlines and low-cost carriers for market domination. Back then, Ryanair was a pipsqueak of an Irish carrier before Michael O’Leary took charge of the company and today, it is a giant in the low-cost space. Back then, Sabena, Iberia and Swissair were national icons before they flew into financial headwinds and today, they have gone bankrupt or have been acquired. Back then, Air France and KLM were the pride of their respective countries despite regularly losing money and today, the merged entity still flies, despite a heavy cost structure and the occasional employee strike. Back then, Lufthansa and British Airways dominated the skies, being fuelled by generous government funding and today, they are the largest aviation groups in the continent, even making money in the occasional quarter. Back then, Alitalia was a joke of an airline, the laughing stock of Italy and the world at large. Today, it still is.

     Always Late In Take-off And Late In Arrival. Unfortunately for Etihad, that was merely the tip of the iceberg, as far as Alitalia was concerned. The Italian flag carrier, largely in the news for its perennial losses, strikes and government bailouts, is by far the best known mascot of an unsustainable Italian Bella Vita, a spirit of living beyond one’s means, the same spirit which led the whole country to the brink in the Eurozone financial crisis. Alitalia, which has rarely turned a profit through the course of its long history, has been flying only due to a stream of bailout packages and government protectionism. It nearly went bust in 2007 but it was privatized in a controversial merger with Air One, which saw Air France – KLM picking up a 25% stake, saving it from certain bankruptcy, in what was one of Silvio Berlusconi’s (of the ‘bunga bunga’ parties fame) rare achievements.

     While Alitalia had avoided certain death, little had changed on the inside. The overstaffed airline had unions that ruled the roost and resorted to strikes at the drop of a hat if their unreasonable demands and salary hikes weren’t effected. It flew all sorts of aircraft from the stables of Boeing and Airbus, which gave rise to heavy maintenance costs and a crippling cost structure. Most of its routes were unviable and it continued to launch new routes and place orders for new aircraft, with profitability seen nowhere on the horizon. It was still no match for Ryanair, Easyjet or even Lufthansa, for that matter. Between 2010 and 2013, Alitalia was fuelled by one bailout after another, despite having been reconstituted a mere five years earlier. By 2013, the airline was in a downward spiral and both UniCredit and the Italian Post had to intervene at the Italian Government’s behest and take stakes in the airline to keep it flying; a classic case of robbing Lorenzo to pay Luigi.

     Yet, the cash burn continued and Alitalia didn’t look like it could keep flying for long. The Italian Government, facing public fury after a financial meltdown and imposed austerity, couldn’t keep throwing good money after bad and needed a more long – term solution. The airline though, had no hope of ever making money, with the unions and the government interfering in its day-to-day operations. Most of the airline’s suppliers were other government entities that charged exorbitantly for their support and services, while bleeding the national carrier. Alitalia and its unions needed to convince or fool an investor into believing that it was indeed worth investing into and could be turned around in the long run. Air France – KLM showed no interest in venturing deeper into the bottomless pit and most other airlines were recovering from a slow business environment and high oil prices. But then, along came a rich Arab and the Italian Government managed to pull the camel hair over his eyes. Etihad picked up a 49% stake in the troubled carrier for over five hundred million Euros in what was a rescue deal worth nearly two billion Euros (from all of Alitalia’s shareholders) and the Italian Government heaved a sigh of relief, having rid itself of a seemingly eternal drain on its coffers. Now, it could meddle in its airline’s affairs without being financially responsible for it.

     Etihad though had grand plans for Alitalia, even as it failed to comprehend the scope of its acquisition and the Pandora’s Box that it had stumbled upon. It wanted to return the Italian flag carrier to the pomp and glory of its heyday and make it the sexiest airline in all of Europe. It revamped everything from the cabin crew’s uniforms to the aircraft livery. But for all the glamour and hype, Alitalia continued to bleed. Etihad’s touch – ups were cosmetic at best. It was more interested in positioning Alitalia as a router of passenger traffic to its network, the economics and financial viability be damned. Furthermore, Etihad never succeeded in gaining full management control of the airline to make a serious attempt at turning it around. It struggled to fight the stranglehold that both the government and the unions had on Alitalia. Alitalia’s unions never allowed it full control and strongly opposed anything that would even slightly jeopardize their interests. Capital infusion after capital infusion happened at Alitalia but to no avail. For Italy though, it was almost as if Germany, France and the rest of the Eurozone were bailing it out of its fiscal woes, while Abu Dhabi was paying to keep its national carrier flying. The Italian Bella Vita flourished.

     Finally, in May 2017, after sinking over two billion Euros into the Italian carrier, only to see it lose several hundreds of million Euros each quarter and shore up a debt of over four billion Euros, Etihad gave the unions an ultimatum. It was a radical cost – cutting plan that sought to turn the airline around by 2019, involving job cuts and reduced salaries, besides route rationalizations and clawbacks on everything from suppliers to spares at Alitalia. The unions, counting on either Etihad or the Italian Government for another bailout, voted in the negative and Alitalia entered administration. Etihad, grappling with ballooning losses at its other subsidiaries as well, finally threw in the towel and the Italian Government turned down a proposal to nationalize Alitalia. For Alitalia, a state of administration was nothing but déjà vu and it found itself facing a scenario where a new buyer had to be found in six months or the airline had to be wound up for good.

          The government’s next move on Alitalia should be an interesting one, given that Italy’s elections are less than a year away. As always, the airline has placed the government between a rock and a hard place. The Italian Government’s loss of a national carrier isn’t exactly a manifesto point but then again, it can’t be seen throwing good taxpayer money after a bad airline. Alitalia has been extended a loan of around 600 million Euros to keep it afloat for the next six months, by when a potential acquirer is expected to surface. But that may be nothing more than waiting for Godot. Alitalia’s high cost structure, its mixed and ageing fleet and most importantly, its unionized labour structure, make for huge deterrents, as far as any potential acquirer is concerned.

     Lufthansa, which has a history of buying bankrupt carriers, has expressed disinterest, while Air France-KLM, which has already burnt its wings with Alitalia, is in no mood to do an encore. While Malaysia Airlines has hinted at buying Alitalia’s aircraft but not the business, British Airways may be a potential acquirer. Incidentally, at the height of its ‘Hunter’ drive, Swissair was flirting with Alitalia for a buyout but the deal never came to fruition. If the ink had indeed wet the dotted line, the Swissair story would have surely had a more painful and expedited ending.

     However, the airlines that are waiting to capitalize on Alitalia’s fallout far outnumber those that may be interested in acquiring it. Ryanair, which has over a third of Italy’s market and which is surely licking its chops at the prospects of Alitalia’s imminent demise, will be the biggest beneficiary in terms of gaining passenger traffic, and Meridiana and Lufthansa stand to gain as well. Alitalia, after all, still has near monopoly over some lucrative routes such as Milan Linate – Rome Fiumicino, not credited to its own strength but due to Italian Government regulations designed to protect the national carrier.

     At the end of the day, a 49% stake isn’t exactly the best place to be from an acquirer’s standpoint, as Etihad has learnt the hard way. On one hand, it isn’t small enough to sit back and look at the target as a passive or a mere financial investment and on the other hand, it doesn’t give the acquirer the right to consolidate the target and take complete control. While Etihad’s 49% stake did give it the right to a few board seats and appoint the CEO, the crucial flaw is that the 49% didn’t allow Etihad to consolidate Alitalia into its books, take full control, do away with the unions and pump as much money as was needed to completely restructure and turn around Alitalia. Moreover, 49% reduced Etihad to the status of playing second fiddle to the Alitalia unions and the Italian government entities holding the remaining 51%, all of which were keen to have their say but reluctant to hand over full control of the airline to the Arab carrier or even work towards creating a leaner and profitable airline.

     Even if Etihad wanted to infuse more equity, it had to have the Italian Government on its side, matching every step with an equal infusion. A unilateral equity infusion would have resulted in its stake rising above 49.5%, which EU laws do not permit. Air France – KLM, which did not put any money into Alitalia, post the initial 25% acquisition, has seen its stake dwindle to less than 2%. Alitalia, meanwhile, seems to be blissfully unaware of the wolf at the door, with another cabin crew strike looming large and the management having announced the launch of 3 new routes in the next few months, along with a ludicrous plan to grow its fleet by 2021. Either Alitalia has already found itself a new buyer and is using the government’s loan to keep itself flying until a big announcement from Etihad at the very last minute or Alitalia seems to be doing what it has done best over the past seven decades of its existence – flying in a fool’s paradise.

     Alitalia isn’t Etihad’s only headache. Its second biggest investment, Air Berlin has ratcheted up huge losses in the German skies as well. Air Berlin, though, isn’t likely to suffer the same fate as Alitalia, at least for now. Despite the daily cash burn, Etihad has committed to fund its losses and see it through to profitability, which will surely entail an outgo of over a billion Euros. In the wake of rising oil prices, Jet Airways’ profits have nearly collapsed from record levels, a clear indicator of the strength of its once – touted turnaround. Virgin Australia too is bleeding, with its recent quarter being the worst in its history. Air Seychelles and Air Serbia are the only airlines in the ‘Etihad Airways Partners’ network that are still making money but then again, they are the smallest of Etihad’s investments. Etihad and Air Berlin are moving 20 aircraft into a new airline venture between Etihad and TUI in Europe, a questionable move at this time, given the precarious financial position of both Alitalia and Air Berlin and more importantly, Etihad’s track record in Europe.

     So, at the end of the day, where does Etihad find itself, with its equity alliance in near shambles? Well, for one, its CEO, James Hogan, the architect of the acquisition strategy, has already resigned and is on his way out. Etihad is rolling back on its splurges and will, in all likelihood, grow organically from here on, in the wake of its subsidiaries’ losses and its own falling profits. The American ban on electronic devices onboard flights from the Middle East to the USA has hit passenger traffic and rising oil prices have crimped profitability. Etihad’s arch nemesis, Emirates has already declared a cutback in some flights to the USA and an 80% crash in profits in its most recent quarter, the after – effects of over 4 years of aggressive expansion led by an influx of A380s and B777s aircraft into its fleet and Etihad is expected to follow suit. After all, while Emirates can fly its A380s 6 times a day to London Heathrow and still make money, flying the new A380s twice a day to destinations like Mauritius, with the aircraft not more than half full, is a clear indication of its desperation to deploy the superjumbos rather than have them sit idle on the tarmac at DXB. The electronics ban, while portrayed to be a security measure in its own right, may just be Donald Trump’s response to the American carriers’ longstanding plea to the US Government against the unfair subsidies doled out by the UAE and Qatari Governments to ME3 (Emirates, Etihad and Qatar Airways), in terms of cheaper fuel, reduced airport handling charges, prime airport slots and unlimited government funding. If the present is a sign of things to come, going forward, Etihad’s fortunes would depend on the whims and fancies of the blond billionaire in the White House, as much as they do on oil prices.

     Etihad, though is doing some fire-fighting. It sold its minority stake in Aer Lingus to IAG, British Airways’ parent company, avoiding a rumoured increase in its stake in the Irish carrier and a likely setup to another failed investment, given that Aer Lingus has been swatted out of the skies by Ryanair on almost every European route. Etihad’s own expansion has been slowed down in the recent past and it has been reshuffling its routes, while moving its A380s to routes that make financial sense rather than deploying them on new routes just to create a buzz. Air Berlin has already leased around 40 aircraft to Lufthansa to cut its losses, in what is widely being criticized as a back door deal between Etihad and Lufthansa. That, coupled with the recent marketing – catering – overhaul collaboration between the Arab and the German giants, may be a prelude to a bigger Lufthansa – Etihad M&A deal. Also, rumours are swirling about a potential Emirates – Etihad merger somewhere down the road, with the aim to promote collaboration rather than competition between the neighbour carriers, a deal which would create an Arabian colossus. However, in either instance of a merger with Lufthansa or Emirates, Etihad would receive the short end of the stick due to its smaller size and failed splurges, succumbing to a bigger and mightier force, a merger that could take place sooner rather than later, turning the feared Hunter into the Hunted. 

     Unlike Swissair though, Etihad isn’t anywhere close to bankruptcy and even if its finances do mask a grimmer picture, Abu Dhabi has enough and more money to pour into its airline. After all, Etihad and ME3, for that matter, were never truly created with a view on profitability and have been and will continue to be fuelled by subsidies; the benefits that they bring to their respective hub cities more than justify their existence (aviation, for instance, already contributes to over 25% of Dubai’s GDP). It may be premature or even audacious to say that Etihad is going to suffer the same fate as Swissair but if there’s one thing that both Etihad and the airline industry can learn from Swissair’s once – infallible ‘Hunter’ drive, it’s that a large bank account and global ambition may buy you a network of feeder carriers but all it takes is a flawed strategy and some turbulent headwinds in the global skies to turn the predator into the prey.