Smith to Forge New
Air France-KLM Jan/Feb 2019

Air France-KLM was the pioneer of the consolidation game in Europe. In the first four years after the 2004 merger between Air France and KLM it made significant progress in showing its rivals how to benefit from a merger of national flag branded airlines. But since the peak of the last cycle and the global financial crisis, the group has lagged its rivals, brought down by excessively weak financial performance at Air France. The group now has a new CEO — remarkably an aviation professional, non-French and non-Establishment — given the task of returning the group to its former glory. Can he do it?

2018 was a bit of a troubled year for Air France-KLM. Revenues on a like-for-like basis were up by 2.5% year-on-year to €26.5bn on the back of a 2.4% increase in capacity and 1.5% growth in currency-adjusted unit revenues. Total passenger numbers increased by a modest 1.1% to 101.4m. Costs were impacted by a 10% increase in fuel costs to grow by 5% and operating profits fell by 30% to €1.3bn down from a restated €1.9bn (the Group adopted IFRS16 at the beginning of the year — see Aviation Strategy, April 2016 "No accounting for leases").

The results were severely impacted by a series of strikes at Air France through the year (which the management estimate cost something around €360m) and not helped by the (now usual) disruption of French ATC industrial action. At the results meeting the management also stated that it expected that the gilets jaunes civil unrest in France towards the end of the year cost it an additional €15m. 

The previous ten years had also been troubled. Over that time the group achieved an average operating margin of 0.5% and lost a total €5.7bn at the net level. Still, KLM has been reasonably successful: it has registered operating profits since 2010 and achieved operating margins of 10% in each of the last two years. The problem has been at the larger Air France. 

A new CEO, a change of culture?

In the first quarter of 2018 the former Chairman and CEO, Jean-Marc Janaillac, fell on his sword. He had tried to bypass the union leadership and appeal to the workforce directly to support the management proposals for renegotiated wage contracts. His brave attempt failed (see Aviation Strategy May 2018) and he resigned in May. 

The Group board took its time to find a replacement but, remarkably, in August appointed British-born Ben Smith, an industry professional with 20 years experience at Air Canada. Remarkable because he knows something about the airline industry, is not French and did not go to the Ecole Nationale d’Administration — and therefore is divorced from the French political establishment. 

He has been tasked with three main priorities by the Group board of directors with the (modest) ambition to regain a sustainable position for Air France-KLM as the leading airline group in Europe: Re-establish meaningful social dialogue within Air France; Simplify and strengthen Group governance to support the Group’s ambition; Develop a “go forward” strategy.

Social dialogue (tackling the unions)

The first task hasn’t taken him long — but then one of his main achievements at Air Canada was the success of renegotiating contracts with their unions — but is surprising given the history of industrial conflict at Air France.

In October the group announced that Air France had signed collective agreements with most of the unions representing 75% of the workforce. In February the company, just before announcing its annual results for 2018, finally was able to announce it had reached a similar deal with the main pilots' union, the SNPL.

We don’t know all the details, and the agreements almost certainly do not go as far as those reached by peers Lufthansa, British Airways or Iberia with their respective unions, but at least it is a starting point for future dialogue.

Importantly, while the agreements include backdated wage increases negotiated for the next few years, they appear to remove extreme restrictions on service flexibility, equality of treatment of Air France versus KLM operations and a revision of base wage scales for cabin crew which will create significantly greater flexibility for Air France in its operations. The company suggests the effects will be neutral on results through improved productivity.

Ben Smith stated that these negotiations had all been done under an umbrella of trust, respect and confidentiality. 

One of the more sceptical analysts at the results meeting suggested to Ben Smith that “we have heard this before from your predecessor... what is different this time?”. The response that came was: “there were no press leaks”. So maybe for the first time Air France really has found the person to tame the unions. 

Corporate governance

Regarding the second task, the Group had already separated the roles of Chairman and Group CEO after the departure of Janaillac. In February just before the release of the annual results, the Group announced that it would set up a new Group CEO committee — chaired by Ben Smith and composed of Pieter Elbers, CEO of KLM, Anne Rigail (new CEO of Air France) and Frédéric Gagey (CFO Air France-KLM) — to determine the strategic direction for all Group airlines and business units. The key goals as he sees it is to simplify and accelerate decision processes, and to maximise overall value for the Group and all its entities.

This at least is a start, but the Group governance still may fall short of the structures established at Lufthansa and IAG. 

Ironically, given Smith’s comments about his negotiations with the Air France unions, in the weeks leading up to this announcement there were a series of press comments suggesting that the well-regarded Pieter Elbers would not have his position as CEO of KLM reconfirmed when his four year tenure expires in April. Apparently 25,000 of KLM’s 35,000 staff signed a petition of support for their CEO, and there were suggestions of strike action should he leave.

Even the Dutch Finance Minister, Wopke Hoekstra, voiced support for Elbers, and “had words” with his French counterpart Bruno le Maire (the Dutch Government still has a non-economic equity interest in the flag carrier for ownership and control reasons).  If anything this highlights the continuing cultural differences between the two airlines.

A “go forward” strategy

The third task may be more problematical.

Ben Smith outlined a handful of first initiatives: improving and simplifying Air France-KLM’s brand portfolio and product offer; simplifying and optimising the fleet; and, thirdly, “boosting our competitiveness”.

He has started on the simplification of the brand portfolio. As a first unsurprising move the Group is to scrap its ill-conceived Joon brand and reincorporate its operations within Air France. It only started operations in December 2017 at the Roissy CDG hub, and had built up to operate 17 A320/321s and four A340s to a handful of destinations. Apart from anything else the new cabin crew collective agreements allow Air France to achieve the cost savings originally envisaged at Joon through other means.

Secondly, it has removed the exclamation mark from its regional domestic subsidiary and added the main French brand to form Air France HOP.  It operates a bewilderingly large number of aircraft types (see table) but at least has plans to phase out the ATRs in 2020.  Not to say that it really makes sense continuing to operate this loss-making regional player under intense competition from the expanding TGV network, but maybe it is a start to winding it down.

That decision will be part of the conundrum of continuing to operate European point-to-point services that don’t touch the main Air France hubs at Roissy CDG and Orly. The company in the past has insisted that these operations are essential to retain brand loyalty for corporate accounts, while not quite accepting that if they cannot be run profitably they may have no place in the network. 

Air France regards itself as a premium airline, but has never really been at the forefront of inflight product development. It has started including the latest full lie-flat business class seats on new aircraft deliveries, but many of the older aircraft retain the uncompetitive 80 degree recline specification. Smith stated that the company is accelerating the retrofit of its fleet to the latest cabin standards — with the first A330 getting its makeover and a plan to retrofit the A380s in 2020. In contrast, KLM completed a full retrofit of its fleet last year.

Meanwhile, it will retain the mixture of subfleet configurations with “right-sized cabins and more efficient aircraft interior configurations to serve each market segment with appropriate gauge and product”. The company also stated that it will, in some unspecified way, “simplify and strengthen the group’s offer through network optimisation”.

The fleet meanwhile, particularly at Air France, has been through a period in the last decade of relative underinvestment: and the group as a whole has no orders in place for its aging A319s and A321s and only has orders in place for 26% of its long haul seat capacity.

The management also expressed the wish to simplify and optimise its fleet. In the short term the group is accelerating the expansion at Transavia with four new 737s planned for delivery in 2019, and will take delivery of six 787s and three A350s in the current year. It had already announced that it will hand back five of its A380s on the expiry of their leases (the other five in the fleet are owned), while the last remaining four A340s will be phased out in 2020 and KLM’s 747s in 2021. It said that it would launch a tender offer for replacement of the medium haul fleet in the current year.

Boosting competitiveness

In his presentation at the results conference, Ben Smith pointed out that this strategy of upgrading and simplifying the product offer and optimising the fleet is all aimed to reinforce the group’s competitiveness. He also expressed further aims to achieve Air France profitability and increase its margin to industry standards; improve operational robustness, reducing fleet constraints and adding spare aircraft at Air France; control infrastructure costs, improve the relationship with Aéroports de Paris and Schiphol; and in Europe, continue to campaign for the implementation of conditions for a level playing field. This all sounds good, but may be no more than an expression of hopeful wishes.

The prime ambition the Board has thrown to the new CEO is to regain a sustainable position for Air France-KLM as the leading airline group in Europe. But if the Board were truly thinking commercially, would the target not be to match IAG’s share price performance.