“It was the spring of hope”:
Air France-KLM targets sustainability November 2019

Paris in November saw the first Air France-KLM investor day for two and a half years. With a new CEO in place the group no doubt considered it was time to try to show that what has been Europe’s laggard airline group now really had something positive to say. What the markets really wanted to hear was the ability for the group to achieve financial sustainability.

Group CEO, Ben Smith, started off by thanking the group’s employees, emphasising that they are the group’s top asset, and stating the obvious that the business revolves round its customers. He continued by revealing that the group would pursue a new value-focused model for all stakeholders — a leading employee promoter score (the best place to work), a leading net promoter score (exceed customer expectations) and satisfy shareholders by reaching top financial performance. All this is to be surrounded by a “commitment to global environmental sustainability” (not that he went into the details on the subject in contrast to the IAG event in London).

This new model seems to be based on three main planks: optimising the operating model; growing profitable passenger revenue; and leveraging European consolidation. Oh, and they also want to develop customer data, the Flying Blue loyalty programme and engineering and maintenance.

Smith had come into a company group with what he saw as an unclear value proposition. He has tried to clarify that. He ditched the ill-conceived Joon (a half-hearted union-bashing exercise), and moved the loss-making French regional HOP! (the only airline in the world with an exclamation mark in its name) back into Air France to leave three master brands: Air France (“showcasing the best of France round the world”), KLM (“strong innovative global brand”) and Transavia (“making low cost feel good”).

He claimed that there now is a clear road map for each of the airlines in the group. KLM will continue to develop its current successful business model. Air France will “leverage its unique assets to build a successful model, one step at a time”. Transavia will “fully leverage its brand power and new-found (French) flexibility”.

This is brilliant marketing-speak that all good airlines employ when trying to convince employees, shareholders and customers that they know what they are talking about. But the underlying message of the day was that Ben Smith is seriously going to try to turn Air France round, narrow the gap between it (on a sub-2% operating margin at the peak of the cycle) and the well-run KLM (on a respectable 10%).

Fleet

One of the first steps is to clean up the Air France aircraft fleet, accelerating the replacement of old fuel-inefficient equipment and reducing the complexity of sub-fleet types. Air France will ditch its ten A380s (although less than ten years old) before they need to undergo expensive heavy maintenance. It will accelerate the replacement of its A340s and concentrate on a long haul fleet of A330s, A350s (of which it has 26 on order, and which will have flight deck commonality) and 777s/787s.

On short haul, Air France has signed an MoU to acquire 60 A220s to replace its aging A318s and A319s — although it has yet to decide on a replacement for its larger A320/A321 fleet.

The regional fleet — especially in France — is a mixed bag of seven types. It will be disposing of the last of its ATR72s, Embraer 145s and E170s to concentrate on E175/E190 and CRJ 700/1000s.

This will reduce complexity: the number of cockpit types will fall from nine to between five and seven (depending on whether it can get common pilot rating on the long haul Boeing aircraft).

KLM meanwhile will concentrate on the 787 and 777 for its long haul operations (which already have common pilot rating) disposing of its A330s and ancient 747s and cutting its number of cockpits from five to three.

Network

Air France is still heavily loss-making on regional and short haul services. It has stated in each of the last ten years that “in the next year or two it will break even”. On one of the investor day charts the management showed that the regional operation was still losing €190m a year, and that its current plans suggested only that it might be able to halve those losses by 2021 and breakeven in 2023. It makes one wonder why they really bother. But Air France has a particular problem: it is politically required to provide services from the regions to Paris, and domestic transverse routes avoiding Paris, even in the face of competition from the TGV (and in spite of a recent call to ban domestic air travel to counter global warming). All part of the 1970s domestic policy of pôles d’équilibres.

Once again it laid out plans to improve profitability on its domestic shuttle routes into Orly, and indeed (with Transavia) improve the utilisation of the valuable slots at Paris’s constrained but convenient second airport.

Revenue mix

More surprising in the management presentation was an admission that the former agreement with the unions made at the time of the merger with KLM to “balance growth” between the two companies had been a complete disaster. This agreement had been made on the basis of ASK growth and block hours performed. The latter had a material impact on pilot performance. The former ignored the fundamental difference between the two companies: KLM is a successful sixth freedom network carrier with minimal direct point-to-point traffic and a necessarily high density configuration; Air France has strong point-to-point O&D demand based at the second largest conurbation in Europe.

But through this agreement Air France was “forced” to under-supply premium seating and maximise loss-making economy (the seats at the back of the bus can produce three times as many ASKs as those at the front). Smith pointed out that in the last five years total long haul premium ASKs from Paris had risen by 5%, but that Air France’s own premium ASKs had fallen by 4%.

Quite remarkably, Ben Smith and his team have been able to renegotiate a new, more flexible agreement with the SNPL pilots which inter alia replaces the ASK metric with a new formula based on maximum seating capacity of the aircraft and removes the former restrictions on the maximum number of aircraft at Transavia France. Air France is now going through the process of right-sizing cabin configurations to boost first, business and premium economy offerings.

The overall target is to bring the group’s operating margins up to around 7-8% on a mid-cycle basis from the current 2019 consensus 4% (€1.15bn). They say that they can’t achieve better because social costs in France are so high — in fact the highest in Europe — and there are some €300m additional tax burdens for operating at the Paris airports in contrast to Amsterdam. (But they say they will lobby to improve the competitive position of French aviation).

The greatest focus is on building returns from Air France itself by increasing its operating profits by €900m — of which €400m is anticipated to come from a simplification focus and restructuring the French domestic network; €300m benefit from the fleet renewal, disposal of the A380s and phase in of A350s, A220s and 787s; and a further €200m from revenue mix optimisation. By 2024 they would hope to have group operating profits of €2.5bn, and stated that they might even then be able to restore dividend payments.

One of the equity analysts asked the management what was really going to be different in this attempt to restructure Air France towards financial sustainability. Ben Smith, Group CEO, Frédéric Gaget, Group CFO and Anne Rigail, Air France CEO, all responded that there was a new-found social cohesion with the French unions. Pieter Elbers, CEO at KLM shrugged his shoulders as if to say “we’ll see”.