Air France-KLMs time to stake a claim on the future: high-stakes poker

As it reported yesterday on a profitable past year, the powerful Air France-KLM Group will be pondering a vital strategic assessment: just how aggressively it should expand capacity in 2008/09 and be prepared to sacrifice profit, in order to establish its place at the head of the table in the new era of aviation.

For that opportunity now presents itself. When we emerge from the tunnel ahead, the aviation world will be a different place.

The Group is now well-established in Europe. In retrospect, the two airlines' timing in making the bold decision to "merge" has proven near-perfect, taking into account regulatory relaxation and the state of the economy. Unlike US airline mergers, being undertaken in the frantic hope of staving off bankruptcy, this was a calculated and orderly move, made against a strong economic background. It was not about current survival, but rather about long term dominance.

Yesterday's annual result, a 13.3% improvement in operating profit over 2006/07, was EUR1.4 billion, contrasting steeply with a final quarter loss, as conditions deteriorated. In view of the previous day's airline share price falls in the US and the unfavourable outlook, Air France shares fell 10%, even as the overall market steadied. But, among its competitors, the carrier is well placed.

Whatever happens next, fuel prices will now weigh heavily on airline planning. Even if the current level, above USD130, is not maintained, the warning alert has been sounded - and there is no shortage of forecasters ready to predict USD200 oil. For European airlines, a large part of the rise has been offset by the strength of the euro, but this effect will diminish in future. So prices at this level and above simply must become integral to corporate planning.

The impact of the recent steep rise in fuel prices and AF-KL's hedging positions can be seen in the contrast between the net-of-fuel operating cost increases in the full year, compared with the final quarter: for the 12 months, costs rose 4.0%, of which only 0.8% was attributable to fuel; for the final quarter, operating costs rose 6.9%, but 4.6% of that was fuel-related.

In these circumstances, airline CEOs may hopefully talk up the prospect of higher air fares to cover higher oil costs, but that is simply not what history has taught us to expect. In an intensely competitive industry, now with relatively low entry barriers, the prospect is always present of a competitor stealing your prey with a good product and cheaper fare. High fares do not help, if people don't buy them.

That said, some airlines are better positioned to protect yields. AF-KLM is one of those. For example, although the Group increased capacity by 5.8% in the recent quarter and traffic only increased 3.0% (for a load factor fall of 2.1ppts), yield remained "resilient", according to M. Spinetta - even if that position too is softening now.

But yesterday, unlike a number of other airlines, there was no talk of capacity reductions from the Group. By contrast, the Chairman announced "Air France-KLM plans a modest and flexible increase in its capacity". This has an ominous ring for its competitors. No indication here of taking a backward step.

The Group is relatively well cashed up, and can afford strategic losses, especially if its opposition is performing worse and there is a realistic prospect of gaining long term benefit, at such a pivotal stage in aviation evolution. Growing market share as others contract can also offer yield premiums, so the long term rewards can spill over into the present. But it is high-stakes poker. It is really betting the farm.

Globally the signs are encouraging for Air France-KLM as it assesses the cards it holds. Inside and outside Europe, the Air France-led Skyteam alliance has been quietly establishing a strong position. The Delta-Northwest combination will certainly help that evolution across the Atlantic, in accessing markets behind US gateways and in North Asian markets, where yields and demand are expected to hold up more strongly.

As the seismic fuel cost developments of the past few days have filtered through, Northwest Airlines for example - a West Coast-based carrier now to be linked into Delta's extensive East Coast network - has reinforced its aggressive plans for expansion into North Asia, already well-founded with over 20 daily flights from Narita alone.

And, as United and US Airways are prompted by fuel costs to pull back from establishing newly-awarded routes to China, Skyteam looks increasingly well-positioned in that potentially massive market. Korean Air, based at Incheon Airport, with near-unlimited capacity for expansion, has not yet fulfilled its promise as a Skyteam member, albeit for reasons beyond its control.

However, liberalisation is now spreading through the North Asian markets, potentially opening up new opportunities for Korean and Skyteam, which also counts China's largest airline, China Southern as a key partner. And Eastern Europe too is reasonably well covered by Skyteam, although Southern Europe still lacks Alitalia, a gap which reality may fill in coming weeks.

So, as Air France-KLM looks around the table this week, it sees many of its fellow players flinching at the elevated stakes. It knows it has one of the best hands, if not the best. All that remains now is to stare the competition down and play the hand boldly.