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Air France-KLM: over half way through 'Transform 2015' plan, "additional measures" are still needed

Analysis

Air France-KLM reported its first positive second quarter operating result for five years as its Passenger segment enjoyed a return to the black, although medium-haul is still loss-making. Low-cost subsidiary Transavia, which now accounts for one fifth of the group's narrow-body fleet, cannot seem to break into profit despite impressive load factors and growth in capacity and revenues.

In spite of the growing use of Transavia, the creation of French regional airline subsidiary Hop and the provincial bases project in France, the group's medium-haul business will struggle to meet its 2014 breakeven target. The Cargo division also remains loss-making in spite of capacity cuts.

Although previously announced initiatives of the group's Transform 2015 restructuring plan are on schedule, Chairman and CEO Alexandre de Juniac is considering additional measures to improve results in medium-haul and Cargo. These will be outlined at the end of Jul-2013 and announced in detail by Oct-2013. More than half-way through the restructuring programme, the more radical steps may still lie ahead.

Operating result improves by EUR158 million in 2Q and EUR239 million in 1H

In 2Q2013, Air France-KLM grew its revenues by 1.2% to EUR6,580 million and turned around from an operating loss of EUR79 million last year to an operating profit of EUR79 million this year, an improvement of EUR158 million. This led to a narrower operating loss for 1H2013 of EUR451 million versus a loss of EUR690 million last year, an improvement of EUR239 million.

Air France-KLM financial highlights 2Q and 1H 2013

This was the group's first profitable second quarter in five years, but much of the improvement in the operating result can be attributed to lower fuel costs, which fell by EUR146 million in 2Q and by EUR160 million in 1H, reflecting lower prices for jet fuel.

The group's gross cash position increased from EUR3.9 billion at 31-Dec-2012 to EUR4.7 billion at 30-Jun-2013. Net debt fell from EUR6.0 billion to EUR5.3 billion over the half year and the group also had undrawn credit lines of EUR2.85 billion. Under its Transform 2015 restructuring plan, it aims to reduce net debt to EUR4.5 billion by the end of 2014.

See related report: Air France-KLM: why it must Transform, as medium haul and cargo operations hurt the bottom line

Passenger segment drives group revenues

Revenue growth of 1.2% was mainly driven by the Passenger segment, which accounted for 78% of group revenues in 2Q2013. By contrast, the Cargo segment continues to struggle, with revenues down 7.7%. Growth in Maintenance revenues of 20% reflected increased third party business. The Other businesses segment saw revenues up 16%, mainly driven by low cost carrier subsidiary Transavia.

Air France-KLM revenues by segment 2Q2013 (EUR billion)

Strong turnaround in Passenger result; more losses in Cargo

The turnaround in the group operating result mainly reflects the performance of the Passenger business, whose operating result improved from a loss of EUR57 million in 2Q2012 to a profit of EUR93 million in 2Q2013. The Cargo segment continues to weigh on the group with another loss, albeit EUR14 million narrower at EUR50 million. Maintenance held its result almost at last year's level, in spite of revenue growth, while Other businesses saw a loss of EUR1 million , after a profit of EUR4 million in 2Q2012.

Air France-KLM operating result by segment 2Q2012* and 2Q2013 (EUR million)

Passenger RASK falls in spite of load factor gains

The Passenger business grew capacity (ASK) by 2.6% in the second quarter and increased load factor by 0.5 ppts to 83.2%. However, unit revenue (RASK) fell by 1.9% year on year in the second quarter, or by 1.3% excluding changes in foreign exchange rates.

Air France-KLM passenger business: 2Q2013 traffic data

Unit revenues were stable in medium-haul (+0.7% ex currency), but long-haul RASK ex currency fell by 1.3%, with a fall of 1.7% in premium and 0.9% in economy. RASK was weakest in Asia and Africa/Middle East. Air France-KLM attributes this long-haul RASK decline partly to record high long-haul RASK in 2Q2012 and also to weakness in Japan, capacity increases in Africa and the "geopolitical situation" in the Middle East. Weak RASK in Asia is also due to competition from Asian and Gulf carriers.

Air France-KLM passenger business: 2Q2013 unit revenue change year on year

Air France-KLM passenger traffic and unit revenue by geography 2Q2013 (year on year change, %)

Cost per ASK in the Passenger segment fell by 4.9% in 2Q2013, helped by lower fuel prices, but the fall of 2.5% at constant currency and fuel was still a creditable result.

Cargo capacity cut, but load factor and unit revenues still fall

The 2Q2013 capacity cut in cargo of 4.2% was focused on the group's dedicated freighter aircraft, whose capacity was down by 18.3% year on year. Air France-KLM says that the context for its cargo activities remains one of weak global trade and industry overcapacity.

Despite the capacity cut, cargo load factor fell 1.1 ppts to 63.0% and unit revenue fell by 5.2% (-4.8% ex currency). The cargo segment's operating loss was reduced because unit costs fell further, at 6.3%.

Air France-KLM cargo business: 2Q2013 traffic data

Air France-KLM cargo business: 2Q2013 unit revenue change year on year

Maintenance profit flat in spite of strong revenue growth

In the Maintenance division, third party revenues grew by 20% year on year in the quarter, helped by new engine contracts and growth in volumes in Air France-KLM's GE contract. It also won new contracts in its component business.

Nevertheless, its operating result was just below stable year on year at EUR37 million (EUR38 million in 2Q2012), affected by a reduction in the work done on its own fleet.

Air France-KLM maintenance business results 2Q2013

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Other businesses see small loss

Revenues from the Other Businesses segment in 2Q2013 increased by 16.4% to EUR397 million, with a 14.2% rise in Transavia revenues and a 22% increase in Catering and other revenues. The segment's operating loss of EUR1 million was split between a loss of EUR3 million for Transavia (see further analysis later) and a profit of EUR2 million for Catering and other.

Air France-KLM Other business results 2Q2013

Employee costs were down as headcount reduces

Group headcount was reduced by 3,300 full time equivalents from Jun-2012 to Jun-2013 (adjusted for changes in the scope of consolidated companies in the group). A freeze in general pay rises at both Air France and KLM meant that there was an underlying fall of EUR98 million, or 2.5%, in employee costs for 1H2013. Non-cash increases in pension-related charges and an increased scope of consolidation offset half of the employee cost savings, so that the reported fall in employee costs was 1.1% for the half year. For 2Q, employee costs fell just 0.6%.

Under the Transform 2015 plan, the group aims to reduce employee costs by EUR400 million between 2012 and 2014 (excluding the non-cash increases in pension charges and the integration of Airlinair). It is on track to achieve a reduction of EUR200 million this year. On a like-for-like basis, headcount has fallen by 5,600, or 5.3%, since Jun-2011 across the group.

At Air France, agreement over headcount reductions has been reached, and cuts are underway, with ground staff and pilots. Ground staff cuts of 1,700 out of an approved target of 2,880 have already been achieved, as have pilot headcount reductions of 160 out of 270. A target to reduce Air France cabin crew by 500 is still the subject of discussions with employees. Any redundancies will be on a voluntary basis.

Air France-KLM change in employee costs 1H2013 versus 1F2012

Fuel costs down; other costs slightly up

Fuel costs, the second largest cost category, fell by 4.5% in 1H2012 in spite of capacity increases, reflecting lower prices. Total costs fell by 0.6%, but ex fuel costs were up slightly, by 0.8%. The increase in costs was mainly due to maintenance costs increasing in line with increased third party maintenance revenues. Costs per EASK (a measure which combines passenger and cargo capacity) fell by 3.1%, or 2.1% excluding fuel and currency.

Air France-KLM costs other than employee costs 1H2012

Transavia losses widen and unit costs grow

Transavia, part of the 'Other Businesses' segment (and, peculiarly, not part of the Passenger segment), widened its operating loss in 2Q2013 from EUR1 million to EUR3 million and in 1H2013 from EUR46 million to EUR54 million. This was in spite of revenue growth of 14% in both 2Q and 1H. Transavia's capacity in ASK grew by almost 20% in 2Q2013 and load factor was up 4.3 ppts to an impressive 91.5% (Air France-KLM's load factor in Europe is 47.7% in 1H2012).

After rapid growth, Transavia had 32 Boeing 737s in the Netherlands and 11 in France at 30-Jun-2013. In total, its 43 aircraft account for almost 20% of the group's narrow-body fleet and a higher share of its short/medium-haul ASKs (reflecting greater seat density and better load factors).

Transavia traffic and financial results 2Q and 1H2013 versus 2012

Load factor gains helped to offset a fall in yield (revenue per RPK was down 3.7%), so that RASK increased by 1.1%.

This suggests that Transavia owes some of its traffic and revenue growth to price discounting, not unexpectedly perhaps, given its start-up-like nature on some routes and its rapid capacity expansion. With little scope for further load factor gains, Transavia will hope that it can continue to grow RASK without discounting yield.

More worrying for Transavia is that, unlike the main Passenger segment, CASK also grew and its growth rate of +1.8% outstripped growth in RASK. CASK at constant currency and fuel price actually fell (-0.8%) and so, given the fall in fuel prices, the difference in these two figures this suggests that currency movements had a particularly negative impact on Transavia's CASK. The reason for this is not clear.

Short/medium-haul 2014 breakeven target is "very challenging"

Increasing use of Transavia France is one of the cornerstones of Air France-KLM's strategy to turn around its short/medium-haul passenger business. Other aspects of the short/medium-haul turnaround plan are a reduction in Air France's narrow-body fleet by removing 16 Airbus aircraft (from 135 in summer 2012 oto 119 in summer 2013); the densification of KLM's 737 fleet; the transfer of Air France's regional businesses into the newly established Hop (with a reduction of 15 regional aircraft this summer); and changes to the French regional bases project, which was originally intended to lead to growth through lower fares and higher productivity, but where capacity is being reduced (and unit revenues are consequently improving).

Although Air France-KLM management says that the operating result of its short/medium-haul business is improving, Transavia's widening losses and unit cost increases suggest more needs to be done. Indeed, group Chairman and CEO Alexandre de Juniac admitted to analysts at the 2Q2013 results presentation that the breakeven target set for short/medium-haul in 2014 is "very challenging".

"Additional measures" needed to improve short/medium-haul and cargo

As a result, in 2014, "additional measures" will be taken to improve results. These measures will include cost reduction initiatives, including a redundancy plan to implement further headcount reductions; "industrial projects", which will involve reallocating capacity between Air France, Hop and Transavia; and commercial initiatives.

These measures are currently being reviewed and outline announcements will be made at the end of Jul-2013, before detailed plans are announced and submitted for consultation to the Works Council by 1-Oct-2013. Similar steps are in progress to improve the situation of the Cargo business.

It seems likely that we can expect further overall capacity reduction in both the short/medium-haul passenger business and in cargo. Air France-branded passenger flights can be expected to bear the brunt of any capacity reductions, while Hop and Transavia will probably grow further.

In the cargo business, additional cuts to the full freighter fleet - or, possibly a total withdrawal of dedicated freighters - may be on the agenda, with cargo retrenching into passenger belly capacity. Meanwhile, CFO Philippe Calavia told Bloomberg that a sale of the Cityjet regional airline subsidiary (not part of Hop) is close to conclusion.

Air France-KLM 2013 profit target below consensus forecast

For FY2013, Air France-KLM has still not given a precise profit target, but it has said that its objective is to see an improvement in the 2H2013 operating result in line with that of the first half. The improvement in the 1H2013 operating result was EUR239 million, so this implies an improvement of EUR478 million for FY2013, implying a target FY2013 operating result of around EUR125 million.

This figure compares favourably with last year's loss of EUR353 million, but is significantly lower than the median forecast operating profit of EUR318 million currently expected by analysts following Air France-KLM (source: Air France-KLM investor relations web page). Given the challenges and uncertainties across the group, management may be right to be cautious over its FY2013 target.

However, its FY2014 target EBITDA of between EUR2.5 billion and EUR3 billion implies an operating result of around EUR900 million to EUR1.4 billion. This will need a much bigger improvement in 2014 than in 2013. When the "additional measures" are outlined in late Jul-2013 and detailed this autumn, there will be little room for caution. The future is nearly here.

See related report: Air France-KLM: it may be unfair to compare its 1Q2013 with Lufthansa's, but…

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