26-Feb-2013 2:33 PM

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

Analysis

Air France-KLM has now reported a cumulative net loss of EUR3.8 billion since March 2008 and a loss of EUR439 million since the merger between Air France and KLM in 2004. Although operationally solid, with load factors reaching 83% in 2012, it remains financially the weakest of the big three European legacy flag carriers and at the wrong end of the scale when it comes to labour productivity. Its medium-haul passenger network and its cargo business are significant drains on its profitability.

Management has set in motion a number of initiatives to plug these drains and to improve productivity, including headcount reduction, the restructuring of its French regional bases, the reorganisation of Air France's regional airlines into Hop, an increase in capacity for its leisure brand Transavia, a reduction in freighter capacity and the development of its alliances and partnerships.

Summary

Air France-KLM reported a cumulative net loss of EUR3.8 billion since March 2008 and a loss of EUR439 million since the merger between Air France and KLM in 2004.
The airline's medium-haul passenger network and cargo business are significant drains on its profitability.
Management has implemented initiatives to improve productivity, including headcount reduction, restructuring of regional bases, and increasing capacity for its leisure brand Transavia.
The company's "Transform 2015" targets to lower unit costs by 10% and increase EBITDA by between EUR1.1 billion and EUR1.6 billion look ambitious.
Air France-KLM reported a 2012 operating loss of EUR300 million, while its net loss widened by 47% to EUR1,192 million.
The group's net debt fell to EUR6.0 billion at the end of 2012, and it aims to reduce it further to EUR4.5 billion by the end of 2014.

Its 'Transform 2015' targets, to lower unit costs by 10%, to increase EBITDA by between EUR1.1 billion and EUR1.6 billion from 2012 levels, and to reduce net debt by a further EUR1.5 billion, look very ambitious. If these targets are not achieved, any return to a falling unit revenue environment could spell disaster for the group.

Operating loss narrows, net loss widens in 2012

Air France-KLM reported a 2012 operating loss of EUR300m, 15% narrower than its loss in 2011, while its net loss widened by 47% to EUR1,192 million (adversely affected by a EUR471 million restructuring charge, which should reap benefits in future years). Net debt fell from EUR6.5 billion to EUR6.0 billion.

Air France-KLM financial highlights 2012

EUR million except where stated	2011*	2012	Change
Revenue	24,363	25,633	5.2%
EBITDAR	2,192	2,405	9.7%
EBITDA	1,344	1,448	7.7%
Operating result	-353	-300	-
Net profit	-809	-1,192	-
Net debt	6,515	5,966	-8.4%
Equity	6,094	4,980	-18.3%
Net debt to equity	107%	119%	+12ppts

A cumulative loss since the merger of Air France and KLM

The group has reported losses in four out of the past five years, during which time its cumulative net loss has been EUR3.8 billion. In the first years after the 2004 merger between Air France and KLM, it appeared that the synergies generated by the combination had led to a structural change in their profitability and it enjoyed rising operating profits - until the year to March 2008. Then came the global financial crisis and profits fell off a cliff as Air France-KLM was the worst affected of the big European legacy flag carrier groups.

The group has reported a cumulative net loss of EUR439 million for the period of its post merger existence. It seems that there was no step change in profitability and that the merger synergies were mainly revenue-related, all but evaporating as soon as the revenue environment became difficult.

Air France-KLM net profit and operating profit (EUR million) 2005-2012

The passenger segment dominates profits, but cargo is very volatile

Looking at profits by business segment, the chart below highlights the importance of the passenger business to the group and also the volatility of the cargo business, whose operating margin has varied from -17.9% to +5.8% since 2005. The maintenance segment has proved to be the most stable and profitable business, but it remains small by comparison to the passenger business.

The passenger business saw its operating loss narrow to EUR235 million in 2012 from EUR375m in 2011. Within the passenger business, Air France-KLM said at the results presentation that medium-haul losses increased by around EUR100 million in 2012. These increased losses stemmed from the regional networks of Air France due to the 'challenging' launch of the French regional bases and the weak domestic French economy; KLM's medium-haul network saw slightly improved profits and the results of Air France's hub activities were broadly stable. The profitability of all long-haul networks improved in 2012.

Air France-KLM operating profit by business segment (EUR million) 2005-2012

Net debt is high, but has stabilised

The group's net debt fell steadily during the early years after the merger, but jumped dramatically from 2008 to 2010, once the global financial crisis hit, as operating cash flow plummeted while group capital expenditure initially remained at pre-crisis levels. Net debt has stabilised over the past four years - reflecting one of management's key goals - due to lower levels of capex and disposal proceeds (in particular from the group's holding in Amadeus).

At the end of 2012, Air France-KLM's net debt position fell to EUR6.0 billion from EUR6.5 billion at the end of 2011, mainly the result of EUR600 million of proceeds from selling part of its holding in Amadeus and lower capital expenditure. Capex was cut from 2011's EUR2.1 billion (EUR1.3 billion net of proceeds from sale and lease-back) to EUR1.6 billion (EUR0.9 billion net of sale and lease back).

The group had gross cash of EUR3.9 billion at end 2012 and undrawn credit lines of EUR1.85 billion. This gross cash position is the equivalent to 55 days of revenues and represents a reasonable cushion, but is less than Lufthansa's 60 days, easyJet's 77 or Ryanair's remarkable 232 days.

Air France-KLM development of net debt and cash 2005-2012

Passenger capacity growth has been modest, but load factors up 4%

The group's passenger capacity has grown at a fairly modest compound average growth rate of 2.5% since 2005. This modest capacity growth has contributed to an increase in passenger load factor from 78.9% in the year to Mar-2005 to 83.1% in the year to Dec-2012 (and also helping RASK in recent years).

Air France-KLM development of capacity (ASK, million) and load factor (%) 2005-2012

Long-haul passenger network drives 2012 revenue growth, but cargo lost

The less competitive long-haul environment continues to help the group.

Group revenues grew 5.2% in 2012 to EUR24.6 billion. Passenger revenues were up 7.2%, in spite of capacity up only 0.6% (below its original budget of more than 2%), driven by a 5.9% increase in unit revenues (RASK). Excluding the beneficial impact of exchange rate movements on RASK, underlying unit revenues were up 3.2%, driven mainly by long-haul activities in 2012, with long-haul ex-currency RASK up 5.0% and medium-haul ex-currency RASK down 1.3%. Supported by its metal neutral joint venture operations, North Atlantic RASK (ex currency) grew by an impressive 10.4%, helped by a 5.3% cut in capacity.

Cargo revenues fell by 2.7% in 2012, the second year of falling cargo revenues, reflecting falling capacity (-3.5%). The maintenance unit saw steady revenues, while the fall in revenues in the 'Other' business segment was mainly due to the reclassification of Martinair's leisure activities to the Passenger business segment. The separate components of the 'Other' division saw contrasting revenue trends, with leisure carrier Transavia reporting traffic revenue growth of 9% to EUR852 million and the Catering division suffering a 7% fall in third party revenues to EUR405 million.

Air France-KLM revenues (EUR million) 2011 and 2012

	Dec-2011*	Dec-2012	Change	% of 2012 revenue
Passenger	18,834	20,186	7.2%	79%
Cargo	3,143	3,057	-2.7%	12%
Maintenance	1,040	1,096	5.4%	4%
Other	1,346	1,294	-3.9%	5%
Total	24,363	25,633	5.2%	100%

Air France-KLM revenues (EUR million) 2005-2012

Looking at traffic revenues by geographic area of destination, the importance of the medium-haul (Europe and North Africa) to the group has shrunk since 2006, although it has returned to growth in the past three years (driven by non-domestic traffic).

The regions that have seen the greatest growth since the year to Mar-2010 are 'Americas and Polynesia' and 'Asia and New Caledonia', perhaps reflecting the impact of the group's partnership with Delta on the Atlantic and SkyTeam's partners in Greater China.

Geographical breakdown of traffic revenues by destination (EUR million) 2006-2012

Geographical breakdown of short and medium-haul revenues by destination (EUR million) 2010-2012

Fuel costs leap by 14% and staff costs by 3%

Operating costs increased in 2012 by 4.8% (this would have been 1.7% excluding exchange rate effects), a little slower than revenues, in spite of a 13.8% increase in fuel costs, which accounted for 28% of total costs.

Staff costs grew by 2.7% and accounted for 30% of costs.

Air France-KLM operating costs 2011 and 2012, EUR million

Year to Dec	2011*	2012	Change	% of 2012 costs
Aircraft fuel	6,438	7,328	13.8%	28%
Chartering costs	571	556	-2.6%	2%
Aircraft operating lease costs	848	957	12.9%	4%
Landing fees and en route charges	1,818	1,862	2.4%	7%
Catering	577	595	3.1%	2%
Handling charges and other operating costs	1,342	1,389	3.5%	5%
Aircraft maintenance costs	1,172	1,151	-1.8%	4%
Commercial and distribution costs	847	876	3.4%	3%
Salaries and related costs	7,460	7,660	2.7%	30%
Amortisation and depreciation	1,642	1,591	-3.1%	6%
All other	2,040	1,984	-2.7%	8%
	24,755	25,949	4.8%	100%

Labour productivity is at the lower end of European scale, targetted by Transform 2015

As the biggest cost item, and the main 'manageable' cost, labour remains a key focus for Air France-KLM management. Labour cost growth in 2012 of 2.7% was less than the growth in total costs, but headcount fell by 1.2% and so employee costs per employee went up by 4%.

Labour productivity, measured by ATK per employee was almost flat year-on-year, but employee costs per ATK increased by 3.7%. The good news is that revenue per employee grew by 6.5%. By comparison with other European airlines, Air France-KLM's labour productivity remains at the lower end of the scale.

Air France-KLM labour productivity measures 2011 and 2012

Year to Dec	2011*	2012	Change
Total full time equivalent headcount	102,012	100,744	-1.2%
Total labour cost EUR mill	7,460	7,660	2.7%
Employee cost per employee (EUR)	73,129	76,034	4.0%
ATK per employee	429	430	0.2%
Employee costs per ATK (EUR)	17.0	17.7	3.7%
Revenue per employee (EUR)	238,825	254,437	6.5%

Improving labour productivity is an important aim of the group's Transform 2015 plan, which is aimed at reducing unit costs by 10%, restoring profitability and strengthening the balance sheet. New agreements on working practices with KLM unions were concluded in Dec-2012. The only outstanding Air France employee group not to have finalised an agreement is the cabin crew, whose three representative unions have signed an agreement that is now being submitted for consultation with employees by mid-Mar-2013.

The draft agreement proposes a freeze in cabin crew pay for the years 2012 and 2013 (2013 and 2014 for KLM), a freeze in promotion to 2016, new working conditions on the long-haul fleet, including a reduction of one or two cabin crew per aircraft, and changes to training and other internal activities. New working conditions are due to be implemented from 01-Apr-2013, with the aim of increasing employee flexibility and the average time worked. The group also aims to continue to lower headcount, mainly through voluntary departure schemes at Air France.

Air France-KLM summary of employee cost initiatives

Aircraft deliveries at a minimum level

Air France-KLM group's fleet amounted to 605 aircraft (of which 573 in service) at the end of 2012. Its 2012 annual report shows that it has firm commitments for only 24 new aircraft deliveries over the next five years and for 43 aircraft in total, including the years from 2018 onwards. The biggest outstanding order is for 25 Boeing 777.

Air France-KLM fleet at 31-Dec-2012

Air France-KLM new aircraft commitments at 31-Dec-2012

Management will stay very busy in 2013

The 2012 results presentation contained a great deal more detail on the outlook than the usual guidance on capacity, capital expenditure and unit costs. Air France-KLM management has its hands full, with many initiatives aimed at turning around the group's financial performance, mostly within the Transform 2015 plan.

These include initiatives surrounding labour (as outlined above), the restructuring of the medium-haul network, the new regional carrier Hop, measures to reduce losses in the cargo segment, developments with partner airlines, and corporate governance/organisation.

Modest capacity growth planned in 2013

Air France-KLM expects to increase passenger capacity by a modest 1.5% (+2.4% long-haul, -2.1% medium-haul) in 2013 and targets a reduction in unit costs excluding fuel, currency effects and pension charge increases. Its own expectation of its markets is that total capacity will grow by between 2% and 2.5%.

Medium-haul restructuring continues

The medium-haul network will see a reduction in capacity of 2.1%, driven by a 6.1% cut in point-to-point medium-haul capacity and a fall of 0.4% at the hubs. At the same time, the group is targeting increases in daily utilisation hours for Air France's A320 fleet, which will reduce in number by 16 aircraft in the summer schedule, and for KLM's Boeing 737 and Embraer 190 fleets.

Air France's regional bases project will see reduced schedules in 2013, with a further evaluation planned for Sep-2013, suggesting perhaps that this long-planned initiative is not gaining the hoped-for traction. The group's low-cost leisure unit Transavia will see capacity increase by 12% and Transavia France's fleet will grow from 8 to 11 aircraft.

Air France-KLM summary of medium-haul network plans for 2013

Air France's regional airlines, Brit Air, Regional (both Air France subsidiaries), and Airlinair (a 40% owned associate) and their fleets of Canadair, Embraer and ATR regional aircraft are to be combined in a new company, Hop, with more than 3,000 staff, offering 530 daily flights and 136 destinations in the summer of 2013. Hop will have a fleet of 98 aircraft in 2013, reduced from 116 aircraft operated by its predecessor companies in 2012.

Cargo capacity cuts, aimed at EUR140 million savings

Air France-KLM has targeted measures to reduce losses in the cargo business by around EUR140 million. Cargo capacity will fall modestly in 2013, by 0.5%, with dedicated freighter capacity down by a more aggressive 6%. The cargo fleet will see three aircraft returned to the lessor, one wet-leased to Etihad and one used in a JV with Kenya Airways on China-Africa routes.

The group expects these capacity measures to yield EUR50 million in cost benefits and sees a further EUR40 million of cost savings from the group's Transform 2015 programme. In addition, it has identified new commercial and revenue management policies that it expects will provide around EUR50 million of revenue benefits.

Partnerships to develop, including North Atlantic, Etihad

The North Atlantic JV with Delta has been renewed for a further 10 years and looks likely to benefit from the imminent new partnership between Delta and Virgin Atlantic, which, it is hoped, will join the existing Air France/KLM/Alitalia/Delta joint venture. It is worth noting at this point that Air France-KLM does not plan to increase its stake in the Italian partner beyond its 25% holding.

The new partnership with codeshare partner Etihad will take a small further step in 2013 with the wet lease by Etihad of one freighter and one A340. (As a possible pointer to the group's future relationship with Etihad, the UAE carrier has just announced a codeshare JV with SkyTeam's Kenya Airways, in which KLM holds a 27% equity share.)

With regard to China, Air France-KLM has JVs with China Southern and China Eastern, generating revenues of more than EUR700 million in 2012, and a codeshare with Xiamen Airlines. In addition, SkyTeam also embraces Taiwan's China Airlines in the Greater China region. The low yielding Chinese market is a difficult one, but SkyTeam is well placed with its partnerships.

RASK vs CASK; unit cost reductions are vital to long term sustainability

Since the year to Mar-2010, when AF-KLM recorded its biggest operating and net losses, its narrowing of losses has been driven mainly by unit revenue growth. Unit costs ex fuel have been contained, falling modestly from the year to Mar-2010 to the year to Dec-2011, but climbing slightly in 2012 (due to adverse exchange rate affects). Overall unit costs have however grown as a result of increased fuel costs.

The chart below illustrates these RASK and CASK trends and highlights how crucial it will be to make greater unit cost reductions to prepare the group for any return to a falling RASK environment. Fluctuations in RASK have tended to be much greater (and less controllable) than those in CASK.

Air France-KLM - index of operating cost per ASK and fare revenues per ASK (each indexed to 100 in year to Mar-2010)

The two key Tensions within 'Transform 2015'

The keys to the success of the 'Transform 2015' plan will lie in Air France-KLM's ability to:

(1) lower unit costs without significant capacity growth; and

(2) lower net debt without diluting product perception and fuel efficiency as a result of an ageing fleet.

A continued benign unit revenue environment - largely outside management's control - will also be very helpful to the achievement of its targets.

A central goal of the plan is to lower unit costs by 10% relative to 2011 levels by 2014. Of course, RASK improvements are not all accidental, helped by a cautious approach to capacity growth, and management retains a cautious stance on capacity. The flip side to this is that more rapid capacity growth would facilitate CASK reduction.

A further goal of Transform 2015 is to continue to lower the group's net debt to EUR4.5 billion by the end of 2014 (from EUR6.0 billion at the end of 2012). This means improving operating cash flow (through better profitability) and containing investments.

The group intends to keep capital expenditure at the low levels seen in recent years, planning EUR1.2 billion of capex (EUR1.1 billion net of sale and lease-back) in 2013 and EUR1.4 billion in 2014, compared with capex levels of around EUR2 billion or more in the mid-2000s.

These lower levels will help cash flow, but risk damaging passenger perception of an ageing fleet, while also limiting Air France-KLM's access to more modern and efficient lower cost aircraft. With an average fleet age in double digits and the only substantial outstanding aircraft order for 25 787-9s (mostly for delivery in 2017 and beyond), this is going to become a considerable issue.