Air France-KLM's "Base Project" A solution to LCC incursion? December 2010

Air France–KLM’s half year results to end September were really quite good — driven by continued excellent performance in unit revenues in both the passenger and cargo divisions (up by a massive 18% and 38% respectively), and the company reported underlying net profits for the half year of €470m against a like–for–like loss of €604m in the same period the year before.

The investor day presentations revolved around strategy: including comments on the passenger business, the North Atlantic joint venture with Delta, and the development of the SkyTeam alliance. There was little really new — with the major exception of the exposition of a new plan to revitalise intra- European point to point services. Many legacy carriers have tried to find ways to offset the incursion of the low cost phenomenon, with little success. Indeed Air France itself two years ago started its own French “LCC” using the expertise of KLM’s Transavia – targeting leisure point to point and charter services, specifically oriented to avoid cannibalising its own mainline traffic. It now seems that Air France has decided to create a new solution.

The plan as presented has the ironic soubriquet of the “Base Project”. The company appears to have an idea to take some of the elements of the traditional low cost KISS principle; single aircraft type, high utilisation, quick turnaround times, point to point services, and no hotac expenses. It plans to establish a series of bases initially at the four largest domestic stations dedicating around ten A319/A320s at each (roughly a third of its total short haul fleet). It will be inviting staff currently based in Paris to volunteer to move to the provinces – but on the condition of changes in working practices. It would like to be able to reduce the number of crew per aircraft per day to around two, and get the crew to work harder each day but be remunerated on a “days on” basis. It plans to be able to put a schedule in place to increase utilisation from the current 8–9 hours by up to 50% to 12 hours a day, including turnaround times of 30–35 minutes.

Most of these “bases” make up the densest domestic routes, on which Air France operates a shuttle service (La Navette), and the management suggested that the first four would be Toulouse, Nice, Bordeaux and Marseilles (from which AF very conveniently has recently managed to oust Ryanair) with the first base opening, depending on union negotiations perhaps, in June 2011. The management stated that the shuttle would remain in place – with the fleet split between Orly and the provincial airport – but suggested that it may think of trying to do the same operational restructuring even at constrained Paris Orly. Increasing the utilisation by over 30% for these base aircraft would automatically lead to a significant increase in capacity on short haul point to point services by around the same amount – at the moment the company is stating that its current plans, without including the effects of the “base” project, show that intra European non hub point to point capacity would be falling by 1–2% annually.

This strategy might sound like one of those traditional airline plans to extricate oneself from an uncompetitive cost structure: grow fast and your unit costs will fall (and AF itself pursued this policy quite well in the late 1990s). In the presentations the management suggested that its strategy would reduce unit costs on operations from the bases by some 15%, with a 27% reduction in manageable unit costs. Worryingly they also stated that the marginal cost of new capacity would be some 50% down on current unit costs, suggesting perhaps that in their thinking they would also look at marginal pricing on the marginal capacity. However, they are seemingly planning to use their traditional product and pricing policies.

If implemented there are likely to be considerable knock on effects on other elements of the domestic market operations. The company hinted that some of the new routes being considered would be those currently operated by its regional airlines (Britair, Regional, CityJet), and that it would probably start redesigning and rethinking the Lyons hub operation. The company rarely gives details of profitability by route segment; but it did point out that the regional carriers last year turned in an operating loss of €82m in FY2010, which they hope to be able to reduce to a €25m loss in the current year.

France has one of the lowest penetrations of its markets by low cost competition at only 20%. True, easyJet has managed to build operating bases at Paris Orly, Roissy and Lyons – but only has an 8% market share of all departing seats (although 6% share on domestic routes). Ryanair has just withdrawn from its first base in France in Marseilles, refusing to be forced into employing crew on French contracts – although with services touching into many secondary airports in France it has a total share of some 9% of the departing seats (and 11% for cross border routes). However, this low overall penetration rate compares with over 50% in the UK, 40% in Spain, around 35% in Italy and Germany.

Air France may be running a little scared that it too could see its dominating control of its home market start to see an accelerated erosion in its market share – and it cannot have been nice to see Vueling announce the establishment of a base in France’s second city Toulouse. AF currently retains a near 85% share of domestic capacity and 52% of all intra European seats departing France. France is heavily centralised: the top ten domestic routes by seat capacity all involve Paris – either Orly or to a far lesser extent Roissy CDG – and account for 45% of total domestic seats; the top 20% of routes by number account for 80% of the seats. Domestic routes on the main corridors have significant competition from the TGV (with the exception of Toulouse – an extension from Bordeaux is planned for 2020), as well as road. Holiday patterns are also heavily concentrated – with synchronised school holidays and half term breaks – giving rise to extreme peaks in travel demand (not exactly conducive to low cost operations). This centralisation may reflect history and cultural myopia – and Air France’s concentration on its hub at Roissy. Some 80% of all intra European seats from France depart from Paris – and Air France itself only operates a handful of routes that bypass Paris; and those from Corsica, Bordeaux and its mini hub at Lyons account for a mere 6% of the non–Paris based French originating intra- European traffic.

The management have recently been emphasising that its métier is to provide transport links between Europe and the rest of the world – hubbing through CDG and Amsterdam. At the investor day the management emphasised that the medium haul operation fulfils two main roles: to provide feed to the intercontinental hubs; and to develop market presence “essential to our marketing tools”. This plan may work. It could also be a very expensive way to maintain frequent flyer membership; but is unlikely to repulse the LCCs.