Deutsche Lufthansa Shares: Up (OTCMKTS:DLAKF)

Following our recent update on International Consolidated Airlines Group, we’re back to look at Deutsche Lufthansa AG (OTCQX:DLAKF, OTCQX:DLAKY). For our new readers, the company is one of the biggest players in the world with a leader position in the EU. In addition to Deutsche Lufthansa, airlines in the company’s network include Austrian Airlines, ITA Airways, Swiss International Air, Brussels Airlines and Eurowings (a local low-cost carrier). The other segments are Lufthansa Technik and its Cargo division. These divisions provide aviation services such as catering, transportation, maintenance, repair and overhaul (MRO) and ancillary activities for the functions of the whole group. We suggest you to check out our previous publication regarding The advantage of ITA Airways.

In short, our previous buy rating was supported by a positive demand trajectory (post-COVID-19), a pilot union agreement and a better balance sheet with a payout ratio. a DPS. With today’s follow-up note and the development of the sector, we see Deutsche Lufthansa as an attractive investment opportunity.

Deutsche Lufthansa Upside

1. Starting from a high-level consideration in the EU aviation industry, what is increasingly favorable is the current production challenge of Boeing and Airbus. Capacity constraints and labor shortages will likely ensure rational competitive behavior and no new airline players;
2. With the consolidation of the American airline industry, we believe that the European one will follow. This change made these companies much more investable. The industry is very competitive; however, Lufthansa is making progress with expansion into European skies. After receiving the green light from the EU to enter ITA Airways, the German giant plans to initially acquire 19.9% ​​of TAP Air Portugal, remaining below the minimum threshold. Therefore, there is no need to notify EU regulatory authorities. Lufthansa’s interest in the Portuguese carrier is due to its links with Brazil, where it is the main supplier, its strong presence in Africa and the expansion of its network in the North American region;
3. Looking at the company, around 60% of Lufthansa’s EBIT comes from air transport, with over 30% from the Technik business and less than 10% from the cargo division. Our buy rating is linked to Lufthansa’s sum-to-part valuation, particularly in regards to the Technik (MRO) division. This is the largest MRO globally and even though this is not a massive margin segment (with an adj. EBIT margin of 10.8% in Q2 results – Fig 1) – the division’s profitability is stable (we assume 7.5 % in our long-term projection) and continues to grow steadily. The MRO division has seen a growth rate of >6% over the past decade. During the outbreak of the pandemic, the company considered selling a stake to raise cash. That said, the division was not sold; however, Bain Capital proposed for a minority stake (20%) an EBIT multiple of 15x, valuing the segment at approximately €8 billion. Deutsche Lufthansa’s market capitalization is currently around €7 billion. Considering Q2 debt (€8.1 billion, including pension liabilities), Deutsche Lufthansa’s enterprise value is €15.1 billion. This implied a valuation of less than 3x on an EV/EBIT basis for the rest of the business. Our team sees the cargo and airline segments as worth more. To be clear, we are not forecasting an MRO write-off; however, this is a margin of safety that cannot go unnoticed.

Source: Presentation of Deutsche Lufthansa Q2 results – Fig 1

Q2 results, revenue changes and valuation

Starting with Q2 financial performance, the figures were in line with Deutsche Lufthansa’s earlier warning. In this quarter, the group’s net profit halved to €469 million, down 47% from the €881 million achieved in Q2 2023 (Fig 2). The company has suffered from a normalization of ticket prices, which remain well above pre-pandemic levels. On top-line sales, the company reported a 7% increase due to higher capacity and the supporting performance of the MRO segment, whose revenue grew 16% over Q2 2023. On a positive note, the company strengthened its balance sheet , reducing net debt from EUR 8.4 billion to EUR 8.1 billion. Lufthansa now says adjusted core operating profit in 2024 will be in the range of €1.4 billion to €1.8 billion (figure 3), with an expectation that Q3 revenue will fall by a single-digit percentage point from of 2023. The company announced a return to regain profitability. This includes network optimization measures such as reducing long-haul aircraft types. This is aimed at reducing cost complexity and streamlining the group’s operation. Given lower fuel costs but incorporating lower yields (the company was down 3.7% in Q2), we adjusted our EBITDA to €3.9 billion and our core operating profit to €1.7 billion EUR. Despite the forecast for higher sales growth, we anticipate an EBIT margin below 4.5% (the company reached 7% in core operating margin in 2023). This is due to headwinds and ongoing strikes. Therefore, we do not anticipate that pricing power will be sufficient to support the company’s 8% EBIT margin target. That said, we see a positive upward trajectory in 2025. In our estimates, the impact of the 2024 strike was over EUR 500 million (the EUR 350 million effect was recorded in Q1). Additionally, due to a more conservative approach to the balance sheet and FCF results, we continue to de-clutter the company over our forecast period. This is another margin of safety.

Even when applying lower estimates (also aligned with the company’s guidance), we still think Deutsche Lufthansa’s valuation is cheap. Given the turnaround program and subdued demand, the company trades at a FWD EV/EBITDA of 3.3x (Fig 4) versus a historical range of 3.6x to 7x. In our estimates, continuing to apply a 4.5x EV/EBITDA, we arrive at an enterprise value of €17.55 billion. Including debt consolidation, our equity value is set at 9.45 billion. Therefore, there is a potential capital appreciation of 35%. We rate the stock a buy and a price target of €7.9.

Fig 2

Fig 3

Fig 4

risks

Downside risks include revenue volatility, which is a function of consumers’ willingness to pay, and unpredictable business travel expenses. Other risks include acts of terrorism and natural disasters. We should also report potential strikes, normalization of ticket prices and increased capacity from low-cost players. In addition, airline profitability is affected by currency changes and fuel price volatility.

Conclusion

Airline production constraints and flag carrier mergers reduce competition and favor ticket prices. In addition, the company is progressing on a deleveraging path and posting record results in the MRO business (Fig 1). The valuation is lagging, so we continue to overweight Deutsche Lufthansa.

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