Berlin is Germany's main tourist destination, and its biggest city, but it is also one of its poorest urban areas. The market has therefore developed into one of Europe's most prominent hot spots for low-cost carriers—and now the legacy airlines are trying to strike back.

Both Lufthansa and Air Berlin—Germany's two most important airlines, are preparing massive changes for their Berlin bases, which could make the city the site of a unique air transport experiment. A major legacy carrier—Lufthansa—is building a large new low-cost division, while a former low-fare and charter carrier—Air Berlin—is turning itself into a hub-and-spoke airline, all at the same time, with the outcome in both cases completely uncertain.

Lufthansa's non-hub operation—effectively all flights not going through Frankfurt and Munich—has been unprofitable for years and efforts to change the situation have been relatively modest so far. That reflects mostly internal politics and concerns about labor unions which have threatened to take a tough stance against any plans threatening existing work rules and rosters. But lately, losses have increased to an unacceptable level. While several bases are still in the running, namely Dusseldorf, Cologne/Bonn and Berlin, industry sources believe Berlin will ultimately win the contest for what could be a massive transformation exercise.

Since Lufthansa has already introduced a higher-productivity network, dedicated fleet and more efficient cabin crew at its Berlin base, so any further expansion will hit its direct competitor, financially struggling Air Berlin.

The ambitious project is currently running under the “direct4u” banner, but the name of the new airline will likely either be Lufthansa, Lufthansa Express or Germanwings. The new short-haul carrier is to combine the fleets of low-fare affiliate Germanwings (using Airbus A320-family aircraft), Lufthansa's non-hub narrowbody operation (around 60 Boeing 737-300s and A320 family aircraft) and 20 CRJ900s, operated by regional subsidiary Eurowings. Not all of the aircraft would be Berlin-based, but if the city becomes the new airline's headquarters, it will also be its most important base.

Lufthansa is seeking a dramatic cut in unit costs for the new carrier; a 30-40% improvement is targeted, with much of it coming from better aircraft productivity and cheaper suppliers that the new carrier will be allowed to choose freely, unlike the parent which still has to use sister companies such as LSG SkyChefs, Lufthansa Systems and Lufthansa Technik when it comes to large contracts.

But whether direct4u can be a success hinges mainly on labor concessions. Lufthansa is in the midst of an increasingly hostile dispute with its flight attendant's union, the UFO. The airline proposed a new contract in mid-August that included no pay increases and longer work hours. The union bluntly rejected that offer and the matter is headed for strikes and mediation. Once the dust settles, Lufthansa will be able to determine exactly what its future cost base will be and whether it will be able to reach the 30-40% cost reduction called for in the direct4u plan. If it does, the new airline will be able to use the group's existing cabin crew staff. Otherwise Lufthansa has threatened to outsource the work.

Air Berlin's task is even more daunting. It is not just about limiting short-haul losses, but about saving the airline. The company is trying to succeed by changing from a lower-cost to a higher-cost business model, introducing a hub-and-spoke system in Berlin for the first time. That was planned to be phased-in with the opening of Berlin's new airport. But given that project's massive delay, with a 2013 opening at the earliest, the airline now has to accommodate six arrival and departure banks at the much smaller Tegel airport, adding further to the cost base of the Oneworld carrier.

The situation for the Berlin-based carrier is desparate and if there is no improvement soon, its future is in doubt. What makes the situation so discouraging is that Air Berlin reported significant restructuring progress in the first half of 2012 after five consecutive years in the red, but financial results still deteriorated mainly because of high fuel prices. Its equity decreased to a mere €101 million ($137.2 million) at the end of the second quarter.

There appear to be only two options for Air Berlin: a much more severe restructuring and downsizing, or another cash injection from its biggest shareholder, Etihad Airways. But even if Etihad CEO James Hogan is willing to help, his room to maneuver is limited. Etihad already owns 29.2% of Air Berlin and cannot go beyond 49% in order not to exceed EU foreign ownership caps. Turkish airline investor ESAS Holdings owns 12% of Air Berlin's shares, so unless ESAS sells some of these, only a minimal additional stake would be available.