Air France-KLM:
Temporary Reprieve Jan/Feb 2016

Seven years on from the global financial crisis and Air France-KLM has finally produced a full year net income worth writing home about. For the year ended December 2015 the franco-dutch group announced net income of €118m up from a loss of €(225)m in the prior year on revenues up by 4.6% to €26.1bn. Operating profits came in at €816m (against a €(129)m loss). More importantly it is the first year since 2008 that Air France itself has managed to generate a full year operating profit.

Both Air France and KLM fell into operating loss in the year ended March 2009 in the wake of the full impact of the crisis and the oil price hike. In the following years KLM was able to produce operating profits (albeit at low margins) but Air France persistently generated losses at this level (see chart). However in 2015 Air France published an operating result of €462m representing a near 3% margin on revenues while KLM returned €384m (a 4% margin).

The group figures for the year are admittedly distorted by comparisons with a strike-torn period in 2014 (the pilots' strike in that year is estimated to have cost the group some €425m at the operating level), inflated by non-current items such as the profits on sale of shares in Amadeus of €218m, sale of Heathrow slots (six previously-leased daily slot pairs to cash-rich partner Delta) for €230m, and deflated by unrealised currency losses of €(360)m, accounting treatment of the change in value of the hedging portfolio of €(225)m and restructuring costs of €(159)m. As this is all so confusing, the group helps us by stating that on an “adjusted basis” the net result would have been €220m up from a €(540)m loss in the prior year.

The headline numbers show revenues up by 4.6% to €26.1bn on the back of a 2% increase in seat capacity, a 3% growth in passenger demand (and a half point improvement in load factor to 85.1%), and a 3% nominal increase in passenger unit revenues. Total operating expenses increased by 3.4% helped by a near 7% (or €500m) fall in fuel costs to €6.2bn despite a 2.8% increase in staff costs. Unit costs (in the passenger network division) fell by 2% in nominal terms.

Two major macro-economic developments worked against the company in the year: foreign exchange movements and fuel.

• The Air France-KLM group is effectively cash flow negative in dollars and the rise in the value of the greenback last year had a negative impact on the results. Overall 26% of revenues are generated but 36% of costs are expensed in US Dollars or dollar-related currencies. As the dollar has appreciated over the last two years the group encountered cash flow “losses” in 2015 equivalent to €178m.
• Although the average market price of jet kerosene fell by nearly 50% in the year (from $908/tonne to $527/tonne) which implies a €3bn fall in the fuel bill, the increase in the value of the dollar exchange rate and the level of group fuel hedging at out-of-the-market prices each wiped out €2.5bn of the potential saving. The management states that for the year as a whole it recovered 30% of the fall in the fuel price (or conversely gave away 70%) but that in the second half of the year recovered 60% of the decline through pricing.

The Group has marginally changed its segment reporting structure. In light of its ambition to grow its LCC subsidiary Transavia it has renamed its passenger division to “Passenger Network” and separately reports results from the low cost carrier.

Furthermore in the passenger network division it is providing more detail of estimated operating profitability by type of operation (see table). In the year to end December 2015 the group estimates that the long haul operations of the passenger network generated operating results of €1.14bn up from €740m in the prior year period; the hub operations at CDG and AMS losses of €(230)m down from losses of €(320)m and that European point-to-point services generated losses of €(70)m as against €(120)m.

Transavia, in line with the company's Transform 2020 plan, is the only airline operation in the group to see growth. Overall capacity was up by 5%, but 25% in Transavia France, with total passenger numbers rising 9% to around 11m (up from 6m in 2011). The company has been repositioning itself in the Netherlands with charter flying down by 13% and scheduled capacity up by 17% year on year. It boasts a unit cost not too dissimilar from that of easyJet, but with unit revenues below unit costs it again lost €35m at the operating level (a -3% margin).

Meanwhile it has made its first move out of its home markets, bravely establishing a base in Munich from March 2016 (using the Dutch Transavia AOC and not that of Transavia France) — a broadsword attack against Lufthansa that is either a brilliant strategic move or will attract aggressive competitive reaction as the German carrier tries to build its own low cost operation. The group has plans to continue strong expansion, building the core fleet from the current 53 737s to over 65 by 2017 by which time it expects to break even.

Among the other divisions, MRO (which benefits overall from dollar strength) and catering did reasonably well in the year respectively generating profits of €214m up by €40m year over year and €37m against €18m.

However, cargo operations suffered an increase in losses to €(245)m. The group is trying desperately to restructure the freight business, and has been disposing of its full freighter fleet. In 2015 it reduced full-freight flying by a quarter (five freighters were phased out during the year) and total freight capacity fell by 6%. With continued weakness in the sector, no pricing power in what is a commodity business, and many competitors pricing at marginal rates or, being unhedged, fully benefitting from the fall in the fuel price, unit revenues fell by 13% on a "like-for-like" basis.

The losses on the full freight operation are stated to have halved to €(42m), implying that losses on belly-hold operations more than doubled to €(203)m (a large part of these losses no-doubt relate to the method of accounting for belly-hold capacity). The group will have reduced its full freight fleet to five units by mid 2016 and is targeting break even on the freighter operation by 2017.

On the balance sheet the group reduced net debt further (under its definition) to €4.3bn down €1bn over the year, equivalent to 3.3x EBITDAR. The net asset value on the balance sheet went positive to the tune of €225m (although this is flattered by a €600m perpetual loan and goodwill and intangibles of €1.25bn). It is probably embarassing to recall that the NAV at the end of March 2008 stood at over €10bn.

What now?

This is one year of profit, and many elements of the group's operations appear to be going in the right direction. But the group has a long way to go to get to achieve competitiveness. Unlike the other two major network carriers in Europe it is still making heavy losses on short haul European operations.

Two of the major elements of the company's "Perform 2020" plan (see Aviation Strategy, September 2014) have yet to be put fully in action: negotiation of productivity agreements with the troublesome Air France unions; and a firm footing for an annual 1.5% reduction in controllable unit costs.

A renewed offer of negotiations for productivity improvements posed in January, which would have allowed a resumption of growth from 2017, seems to have been rejected out of hand (with strike threats). Recently, however, Air France won an appeal in the courts which appears to have confirmed the right of the Air France CEO Frédéric Gagey to make strategic decisions — the pilots' union had apparently suggested that these should be overturned if less senior managers or other staff disagreed. (This surely could only happen in France.) Meanwhile, at the end of February, the Air France management started discussing with the works' council another round of 1,600 voluntary redundancies, primarily among ground staff.

At the results meeting the management did not give a huge amount of guidance, but plans continued capacity "discipline" with network airline capacity growth of around 1-1.5%, (down at Air France and up at KLM) and points to its fuel bill falling €1.5bn to €4.7bn with non-fuel unit costs down by 1%. The key for this year will be how much of the fuel benefit it gives away to passengers.

At the time of the results, group CEO Alexandre de Juniac stated "our position relative to our main rivals hasn’t changed. We still need to ask for additional reforms if we want to bridge the gap in competitiveness, if we want to lower costs and be able to buy planes, hire workers and grow in a sustainable manner”. The fear maybe is that they will not now be able to convince the unions quite how far those reforms have to go. From the unions' perspective, the upturn in financial performance justifies their protectionist stance.