Air France-KLM: Getting ready to perform September 2014

September saw Air France-KLM hold its first investor day in two years. With its medium term restructuring plan “Transform 2015” scheduled to mature next year, the event was heralded to include a longer term strategy named “Perform 2020” by which the group would present its view of how it would progress in the next five years and beyond.

There are many similarities between the Air France-KLM strategy presented with that recently highlighted by the Lufthansa Group (see Aviation Strategy, July/August 2014). As with its German rival, it plans to continue to limit mainline capacity growth, concentrate on a continuous reduction in unit costs, emphasise long haul joint ventures, target growth in its MRO business, and start a major expansion of its own low cost operator. It will also continue to limit capital expenditure (despite its long haul fleet renewal) in order to further reduce debt.

According to the Air France-KLM management, this new five year plan will be a “strengthened enterprise model” built on the traditional stake-holder triangle:

• Customers: the carrier of choice in all the markets in which it operates,

• Employees: a committed workforce participating in the success of the group,

• Shareholders: a de-risked profile delivering consistent growth and value.

The “Perform 2020” five year plan has an overall target of improving total group profitability to generate returns on capital employed of around 10% by 2017 (it was less than 3% in 2013 without accounting for the losses at Alitalia). To do that it will need to increase EBITDAR (earnings before interest, tax, depreciation and rentals) by around 9% a year for the next four years. This would bring it close to touching the peak 16% EBITDAR margin it last achieved in 2007.

It expects to achieve this target from higher profits in the passenger hub business, a return to operating profit breakeven in the point to point business, improved performance from an expanded Transavia, a return to breakeven for the cargo division, and higher profits in the maintenance and catering segments.

Cargo

Air France-KLM had already take the decision in its Transform 2015 restructuring plan to reduce its exposure to full cargo aircraft. KLM finally acquired full control of Martinair in 2008 and in the financial year 2008/09 the Air France-KLM group was operating 25 full freighter aircraft. By 2013 it had removed eleven aircraft form the fleet and full freighter capacity had fallen by 50%.

It has now taken the decision to accelerate the phase out of the last remaining five MD11-Fs in Amsterdam (on top of the five aircraft announced for disposal in October 2013). As a result the group cargo operations will have three 747-ERF based in Amsterdam and two 777F based in CDG; by 2017 the group's full freight cargo capacity is expected to fall by another 50%, and full-freighter cargo capacity is planned to account for only 15% of total freight capacity (although, of course, KLM continues to operate its combi-aircraft with their high and variable belly capacity).

The management stated that the fleet of freighter aircraft, despite the restructuring programme had still lost €110m in 2013 (out of total cargo operating losses of €202m). The target under the new plan is merely to get to break even by 2017.

Rationalising the decision to retain full freighter aircraft, KLM CEO Camiel Eurlings argued that the ability to be able to offer freight forwarders the specialised lift that full-freight aircraft can provide (especially for oversized consignments, those needing front nose loading, or products prohibited on passenger aircraft) automatically provided it with an uplift in unit revenues of 20% and has a knock effect on increasing yield in belly-hold operations. In the meantime the group has also introduced a new cargo commercial policy including a significant push on higher margin specialised products (such as pharmaceuticals, animals — and no doubt flowers). At the same time the group will reposition the smaller full freight aircraft on niche markets, chartering, routes with low passenger services and limited belly-hold capacity and oversize products.

Passenger business

One of the mantras from the management is “capacity discipline”. The group plans to continue to increase capacity by no more than 1-1.5% a year overall for the next three years (of which long haul would provide growth of around 2%, short haul hub feed remain static, and a decline in non-hub short haul point-to-point capacity). In doing so it will concentrate on developing long haul joint ventures to help it counter the impact of the super-connectors. Apart from the long established immunised JV on the Atlantic with Delta, and the stake in Kenya Airways, it is in the process of trying to develop deep relationships with China Eastern and China Southern, has taken a 3% stake in Gol in Brazil, and says it is trying (forlornly perhaps?) to negotiate some form of revenue share agreement with Etihad.

On short haul hub operations it is in the process of increasing seat density (and at KLM reducing turnaround times) on flights into the hubs, and states that it will reduce capacity on weakest routes and “enhance the portfolio of medium haul destinations and frequencies”. Rather disturbingly perhaps it is also looking to increase the short haul to short haul connection potential at the hubs (short haul hubbing does not work at all well in Europe). Almost in the same breath, the management suggested that there has been a change in customer perception of connection times and that this is no longer a criterion in flight selection; as a result it would be looking to “investigate opportunities to adjust hub organisation”.

For once the group showed details of the relative profitability of the passenger business (see table below). In 2012 the group's hub operations made a small operating loss which rebounded to a €400m operating profit in 2013. The management suggested that this could double in 2014 to around €800m and presented a chart portraying continual regular growth over the next three years.

Short haul point-to-point

The real problem is on short haul operations that do not form part of the hub systems — a factor particularly pertinent to Air France. As for all the legacy carriers in Europe, short haul services are under significant competitive pressures from LCCs. Air France has an advantage in that France is a highly centralised nation (all routes lead to Paris), has the second largest catchment area in Europe for air travellers at is base in Paris, and — to a certain extent — that it has had significant domestic competition from the TGV for many years. It also has dominant slot positions at the two main Paris airports.

However, it seems to adhere to the belief that it needs to operate short and medium haul services that do not touch its hubs, in part to maintain increased market presence to gain perceived benefits through the frequent flyer programme.

For the first time the company pointed to the relative profitability of the segments of its point-to-point short haul business (see chart xxxx). In 2012 non-hub flying generated losses of €240m (presumably excluding the losses of recently disposed CityJet). The results for 2013 improved slightly despite the disastrous plan to expand quasi-low cost operations from regional bases. In 2014 the group suggests that total losses in this sector will have reduced to €140m.

Within this result however, the core Orly shuttle business from Paris to the main regional cities in France only produced a small loss, the regional HOP! Operations (encompassing the former Britair, Régional and Airlinair) lost about €25m, secondary European route operations from Orly lost around €45m and the point-to-point services from regional airports to other destinations in Europe lost around €65m. The measures included in the Transform 2015 plan will remove around €50m of these losses (mostly the winding down of the ill fated plan to expand regional base European operations) but this still leaves losses of €90m to recover — and under the new plan the company would like to bring it to break-even by 2017.

Air France regards the point-to-point network as a significant asset:

• €1.7bn revenues, 15m pax and 34 stations

• 38 A320s and 61 regional aircraft

• 77% market share Paris-Orly to regions

• 50% market share inter-regional

• Dense domestic network and large customer base increase efficiency of loyalty programme

The group has already gone through a significant level of restructuring of the system as part of the Transform 2015 plan. Total point-to-point capacity has fallen by 25% in the past two years (admittedly partly resulting from the disposal of CityJet), regional bases have been “resized” and the regional services have been brought together under a single network and brand of HOP! It has been able to achieve a reasonable increase in aircraft utilisation, an 8% reduction in station unit costs, and reduced staffing levels by 14% through voluntary redundancies since 2012. At the same time on the regional services it has introduced new commercial initiatives — including a new leisure pricing offer, a revamped business tariff, and a discount pass which have so far this year generated a near 6% increase in unit revenues and a four point improvement in load factors.

From early 2015, the company will rationalise the Air France point-to-point operations and HOP! Into a single business unit, which in conjunction with further tweaking of the network is seen to help it towards a target of break-even by 2017.

Transavia

Air France seems to have embraced the idea that the way to deal with the growth of competitive LCCs is to develop its own in-house pan-European low fares carrier (although very few legacy carriers have been able to do so successfully). As a result it announced plans to expand the operations of Transavia significantly towards a base fleet of 100 aircraft by 2017 up from the current 44 units (30 in the Dutch-based Transavia and 14 in Transavia France).

Currently Transavia operates 200 routes with 870 flights a week to 85 destinations using an all 737 fleet. In 2013 it carried 9m passengers, generated just short of €1bn in revenues (30% in France) and an operating loss of €23m. It operates from bases in Amsterdam, Rotterdam, Eindhoven, Orly, Lyons and Nantes. It boasts a unit cost not too far from the levels of easyJet or Vueling — but, as it still operates a significant level of non-scheduled flights (charter represents just under 50% of the Dutch operations), it has a substantially longer average stage length. It boasts a strong brand position in the Netherlands, growing awareness in France but limited presence outside its home markets.

The idea is to move towards a pan-European scale. Over the next three years the management stated that it would continue its pace of growth at Orly — up by 15% a year in the last two years. (And Air France, with just around 50% of the slots at the constrained airport, has the ability to provide it with a substantial valuable base for growth.) Air France CEO Frédéric Gagey was keen to emphasise that although the group was giving slots to Transavia at Orly at the same time as closing loss-making AF routes from the airport, this did not mean a transfer of point-to-point services to the low cost carrier, but the opening of new destinations under the new brand.

It would also aim to open between five and ten bases outside its home markets (presumably at the end of routes currently served), targeting the number two or three market position with three to ten aircraft at each base. By 2017 it is targeting to be one of the top five largest LCCs in Europe, the low cost leader in the Netherlands, the largest international airline at Orly, over 20m passengers a year. Up to 2017 the significant expansion will have a negative impact on profitability but the management expects to break-even in 2017 and be able to deliver a medium term operating margin above 5%.

Of the hundred aircraft in the fleet by 2017 it was envisaged that one third each would be operated by the Dutch operation (implying no further growth there), Transavia France, and a new Transavia Europe (operating under an AOC from another country).

When Transavia France was established, the group had been limited by union accord to operate no more than 14 aircraft in the new unit. The group CEO Alexandre de Juniac accepted that they would have to renegotiate with the pilots' unions to lift that limitation; and that if they did not agree, Air France-KLM would concentrate on expanding Transavia Europe. In addition he was adamant that the LCC could not afford to be bound by current Air France working terms and conditions.

Somewhat surprisingly, Air France does not seem to have pre-negotiated its plans with the pilots. The two main unions, SNPL and SPAF, complained that they had not been consulted. They started strike action with demands that current Air France working conditions, scope clauses and seniority lists apply to all Air France owned airlines. Also, bizarrely, the unions demanded that Transavia France should operate A320s. The two weeks' strike is likely to have cost the group some €250m.

Air France-KLM has remained adamant that Transavia France will not be viable under those terms. However, it has apparently prorogued the agreement to limit the Transavia France fleet to 14 aircraft; and, in an attempt to resolve the industrial action, backed down from establishing Transavia Europe. At the same time it has emphasised that Transavia will operate fleet with a single aircraft type — the 737 — while it would have separate employment terms and that (somehow) it will maintain a single seniority list. The SNPL strike has ended without resolution of the disagreements.