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Air France and KLM? October 2015 Download PDF

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Leading up to the peak of the last cycle in 2008, Air France-KLM had managed to convince investors that the 2004 merger with KLM was working: operating profits increased and the first-mover advantage of removing a major competitor along with providing joint-hub pricing suggested that consolidation in Europe could really work.

This in itself persuaded its major competitors — BA and Lufthansa — that it was a “good idea”, and spurred on the era of European consolidation. Since then the group has lost a total of €6bn at the net level and €2bn in operating results. The group's market capitalisation on the stock markets has fallen from a peak of €11bn to €2bn now.

It is unusual, but perhaps an aspect of the original merger deal, that KLM, the acquired airline, still makes public its annual reports. KLM, an expert at 6th freedom traffic and having a relatively low level of pure O&D demand, has been able to generate underlying operating profits of €1.1bn and net profits of €0.5bn in the past five years (see chart page 2). This only represents an average operating margin of 3% — insufficient to cover the cost of capital maybe, but at least positive. This is in significant contrast to the results for the group as a whole.

There appear to be many differences between the two carriers. KLM's staff costs are 25% of revenues, compared with 29% for the group as a whole (and 32% for the group excluding KLM) — and this is despite having a slightly higher average number of pilots and cabin crew per aircraft. Industrial relations also appear markedly in contrast. KLM seems to have a better ability to negotiate consensual pragmatic agreements with its unions.

Air France in contrast had a significantly damaging strike this time last year (costing over €400m), and is caught up in a major fight with its pilots over productivity, pay and future direction of the company. This culminated in a public brawl early in October, with physical attacks on senior management.

Annette Groeneveld, the leader of the Dutch carrier's cabin crew union, was recently quoted as saying “At KLM, we have been able to strike a deal between the pilots, cabin crew and ground staff to reduce labour costs, and improve the efficiency of KLM... KLM did not enforce anything on us. We have been negotiating for a very long time and we struck a deal in the best interests of the company. I must admit I don't know what Air France is doing... negotiating by the unions in France is a bit difficult because I think that French culture is difficult, well different at least.” Cultural differences still lurk across borders in Europe — and the Dutch unions do not have the same history of anarcho-syndicalisme.

On of the major reasons for the disparity is costs arises from the substantially higher rate of employers' social costs in France which makes French companies less competitive in hiring employees from a global workforce such as pilots. In the graph below we show data extracted from a KPMG study of comparative employment costs showing that for an advertised salary of $100k per annum a French company could have to pay over 50% on top of the salary to the government and the French based pilot would take home less than 30% of what he could achieve if employed in Qatar. (Hardly surprising that Ryanair has decided not to base pilots in France).

Balance sheets

KLM's net asset value at the end of 2014 was virtually zero — although this was affected by writedowns against reserves of some €1.6bn in the year from pension fund revaluations and cash flow hedges. Reclassifying its cumulative preference shares and perpetual subordinated loans to equity would boost the NAV to over €600m. In contrast the Air France-KLM group balance sheet showed a negative shareholders' funds of €(0.6)bn (since the year end this has been covered by a new perpetual loan treated as equity) — although the underlying level excluding the carrying amount of intangible assets would be nearer a negative €(1.9)bn (and this is against net debt of €6.2bn at the year and and €5bn at the end of September 2015).

The group has been trying hard to recover profitability since the financial crisis. It's first restructuring plan entitled Transform 2015 was designed to return it to a level of profits sufficient to provide a return to shareholders in excess of cost of capital by 2015 (the same targets were made by IAG and Lufthansa — but only IAG it seems will achieve it). This proved impossible as the economic performance in Europe flat-lined and, while fuel has fallen substantially, locked-in fuel hedges have restrained the benefits as industry ticket pricing has been led by carriers benefiting fully from the decline. Last year the group extended its target return to profitability to 2017 through a new programme “Perform 2020”.

Plan “A” was to continue to grow at around 1%-2%, concentrate on unit cost reductions, develop Transavia into a pan-European LCC (or at least eventually transfer more of the Air France non-hub flying into a leaner operation). Failing to negotiate with the French pilots, plan “B” is to shrink into profitability. (This is far harder to do — but BA did achieve it fifteen years ago). It will focus on cutting its long haul capacity by 10% between 2015 and 2017 and reduce the long haul fleet from 107 aircraft to 93. If it fails to reach agreement with the French unions it may well accelerate the shrinkage further. Plan “C” no doubt is to push more activity towards a more efficient KLM — getting rid of the implicit agreement for parallel equal growth.

Plan "D", which only exists in the minds of some interested observers, might be a de-merger.

Air France-KLM Lufthansa IAG
€m 2015 2014 2015 2014 2015 2014
Revenues 19,714 18,717 24,304 22,624 17,119 15,155
Operating result 666 40 1,663 1,048 1,805 1,130
Net result -153 -526 1,748 482 1,180 694
Operating margin 3.4% 0.2% 6.8% 4.6% 10.5% 7.5%
AIR FRANCE-KLM FINANCIAL RESULTS Produced by GNUPLOT 5.0 patchlevel 0 -2,000 -1,500 -1,000 -500 0 500 1,000 1,500 2,000 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015F 2016F 2017F 15,000 20,000 25,000 30,000 EURm Operating profits Net Profits Revenues Operating profits Net Profits Revenues

Note: 2003-2010 Years ending March in following year. 2011 on years ending December. Source: Company reports. Concensus forecasts.

AIR FRANCE AND KLM OPERATING RESULTS (€m) Produced by GNUPLOT 5.0 patchlevel 0 -1,400 -1,200 -1,000 -800 -600 -400 -200 0 200 400 2009 2010 2011 2012 2013 2014 EURm KLM AF Group KLM AF Group

Note: KLM operating result from KLM Annual reports. AF operating result = group operating result minus KLM operating result.

TAX & SOCIAL COSTS FOR USD100,000 SALARY Produced by GNUPLOT 5.0 patchlevel 0 0 20 40 60 80 100 120 140 160 France Italy Germany Norway UAE UK Netherlands Ireland Qatar Australia USA HKG $'000 Takehome pay Income Tax Employee SS Employer SS Take-home pay Income Tax Employee SS Employer SS

Source: KPMG 2011. Figures estimated for unmarried individual without children.

AIR FRANCE-KLM GROUP SHARE PRICE Produced by GNUPLOT 5.0 patchlevel 0 5 6 7 8 9 10 11 12 2013 2014 2015 AF.PA

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