12-Dec-2014 11:47 PM

KLM: a decade after Air France merger, the smaller, but more profitable partner also needs cost cuts

Analysis

KLM, the world's oldest airline still operating, turned 95 in Oct-2014, after passing the 10th anniversary of its merger with Air France earlier this year. A pioneer of the international hub and spoke model, KLM's continued operational effectiveness is illustrated by its industry leading load factor. Although, before the merger, it often struggled for profitability, it has consistently achieved higher operating margins than its sister airline Air France since their 2004 union.

In spite of these marks of success, KLM CEO Pieter Elbers, promoted to replace Camiel Eurlings in Oct-2014, is asking employees to suggest ways of making cost savings of EUR700 million over five years. This is to fund widebody upgrades and service enhancements, including new seats for 15 Boeing 777 aircraft and business lounge expansion. KLM is also placing a freeze on new cabin crew hires and giving consideration to job reductions.

Much of the commentary on Air France-KLM Group's new Perform 2020 programme has focused on Air France, loss-making since FY2009. In this report, we look at KLM's post merger track record at a time when its margin is under pressure.

Summary

KLM's operating margins have been consistently ahead of Air France-KLM's, but are under pressure in 9M2014.
KLM's profits have not tracked revenue growth since the merger with Air France in 2004.
KLM's passenger load factor is at industry-leading levels, but further gains may be harder to achieve.
KLM's revenue recovery post-financial crisis was stronger than Air France-KLM's.
KLM's costs have grown faster than revenues since FY2011, despite headcount reduction.
KLM's current cost-saving program is crucial to reverse the trend of costs outpacing revenues and restore higher levels of profit.

KLM's profits have not tracked revenue growth since the merger

In the year to Mar-2005, the first financial year after the merger with Air France, the KLM Group's revenue was EUR6,442 million. This rose by 50% to reach EUR9,688 million in the year to Dec-2013 (the group changed its year end from Mar to Dec in 2011). KLM's share of Air France Group revenues increased from 24% to 38% over this period.

However, KLM's operating result fell by 36% and its net result by 48% over the same period. In fact the intervening years saw considerable volatility in both revenues and in profits as the airline cycle peaked before the global financial crisis and then came crashing down in 2009 (KLM's year to Mar-2010).

KLM incurred net losses in the years to Mar-2009 and Mar-2010, but only suffered an operating loss in the second of these two years. Since then, it has consistently made an operating profit, but at lower margins than before the crisis. In FY2005 to FY2008, KLM's operating margin rose from 7.2% to 9.4%. Since the crisis, its highest margin has been 4.4% and its 2013 margin was only 3.1%.

KLM Group revenue (right hand axis), operating result and net result (left hand axis), EUR million FY2005 to 2013, 9M2013 and 9M2014

KLM's operating margins have been consistently ahead of Air France-KLM's, but under pressure in 9M2014

In 9M2014, KLM's revenues reversed their recovering trend and dipped by 1%. Moreover, its operating result fell by 17% and its operating margin contracted by 0.6 ppts to 3.2% for 9M2014. Its operating margins have consistently been higher than those of the Air France-KLM Group throughout the post merger period.

Until quarterly results released in 2014, Air France did not report separate financial results. Moreover, consolidation accounting effects mean that the Group results are not simply the sum of the two major operating companies' results. Nevertheless, it can be deduced that Air France has not recorded an operating profit since the year to Mar-2008. Air France revenues fell by 5% and its operating loss more than doubled in 9M2014.

It has only been KLM's profits that have kept the group anywhere near breakeven in recent years.

KLM's current dip in margins, at a time when sister company Air France's pilot strike has pushed it further into loss, puts pressure on the Group as a whole.

Operating margin (% of revenue) for KLM Group and Air France-KLM Group FY2005 to 2013, 9M2013 and 9M2014 and for Air France 9M2013 and 9M2014

KLM's ASKs up 15% since the global financial crisis and load factor is at industry leading levels

A direct analysis of the relationship between KLM Group revenues and costs and its traffic performance is hindered by the fact that the KLM annual report reveals financial results for the consolidated KLM Group, but only shows traffic data for the KLM parent company. This prevents the calculation of meaningful CASK data, for instance. The KLM Group includes subsidiary airlines Transavia, Martinair and KLM Cityhopper.

Nevertheless, we can look at KLM parent's capacity growth and the development of the KLM Group's revenues. The KLM Company increased its ASKs by 33% between FY2005 and 2013. Its share of Air France-KLM Group ASKs increased from 35% to 38% (but note that this share does not include KLM's subsidiaries). It reduced ASKs by 4% in FY2010 during the global financial crisis, but grew by 15% from then to 2013.

Passenger load factor has risen through the post merger period, moving from 81.9% in FY2005 to 85.8% in 2013, although it fell during the crisis. Passenger load factor gained more than 4 ppts from FY2009 to 2011, although it then remained on a plateau. KLM's load factor has consistently been higher than that of Air France-KLM Group (83.7% in 2013) and of the average for members of the Association of European Airlines (79.9%), but it may be harder for it to make further meaningful gains.

KLM Company available seat kilometres (ASK), revenue passenger kilometres (RPK) and passenger load factor FY2005 to 2013

KLM Company and Air France-KLM Group passenger load factor (%) FY2005 to 2013

KLM's revenue recovery post financial crisis was stronger than Air France-KLM's

After it made a loss in the crisis year, FY2010 (year to Mar), when KLM's revenue fell 9%, it achieved a 30% revenue rebound by 2013 (compared with a rebound of 23% in Air France-KLM's revenues over the same period). This was driven mainly by a 41% increase in passenger revenue from FY2010 to 2013, while cargo revenue grew by 20%.

In 2013 itself, KLM's total revenue grew by 2%, with passenger revenue up 4% and cargo revenue tumbling by 8%. The challenges faced by the cargo business, including a structural overcapacity problem, have led to a decision to phase out KLM's MD-11 freighters, leaving only three Boeing 747-ERFs in its full freighter fleet by 2016. The Air France-KLM Group's revenues were flat in 2013.

See related reports:

KLM Group revenue by activity (EUR million) FY2005 to 2013, 9M2013 and 9M2014

KLM's annual reports give details of its passenger yield per RPK and we can combine this data with is passenger load factor to calculate passenger revenue per ASK (PRASK).

KLM Company passenger yield per RPK and passenger revenue per ASK (EUR cent) FY2005 to 2013

The chart below shows KLM's PRASK together with that of the Air France-KLM Group and highlights the Dutch operator's PRASK discount relative to the Group average. In 2013, for example, KLM's PRASK of EUR6.3 cent was 10% lower than Air France-KLM's EUR7.0 cent. This is partly due to KLM's longer average trip length, but also reflects its greater reliance on transfer traffic.

Nevertheless, KLM's PRASK has enjoyed a stronger recovery from the financial crisis than that of the wider Group. From the trough in FY2010 to 2013, this indicator increased by 23% for KLM and only 14% for Air France-KLM. Moreover, KLM's 2013 PRASK was 5% above its pre-crisis peak, whereas Air France-KLM Group's PRASK was still 1% below the peak.

KLM Company and Air France-KLM Group passenger revenue per ASK (EUR cent) FY2005 to 2013

KLM's costs have grown faster than revenues since FY2011 in spite of headcount reduction

KLM Group's FY2010 revenue drop of 9% was faster than the ASK cut of 4% and not matched by the 3% reduction in costs, leading KLM into an operating loss. The return to profit in FY2011 was driven by a 16% rebound in revenue, outpacing cost growth of 7%. Although it has remained profitable since FY2011, KLM's costs have increased faster than its revenues and faster than the company's ASKs since that recovery year.

After increasing in the years before the financial crisis, the average number of full time equivalent employees has been on a downward path in recent years. KLM Group average headcount was 10% below its FY2009 peak in 2013 and KLM Company headcount fell by 5% over this period.

According to a KLM spokesman, the airline will not make a decision on job cuts, as part of its cost saving programme, ahead of union negotiations on 18/19-Dec-2014 (Bloomberg/The Loadstar, 08-Dec-2014). Talks are planned with five pilot, cabin crew and ground staff unions.

KLM Group and KLM Company average headcount: FY2005 to 2013

Labour productivity has improved, but has further to go

By two important measures, employee productivity has improved in recent years. Since headcount peaked in FY2009, ATK per employee is up 4% for the KLM Company and revenue per employee is up 31% for the KLM Group.

This puts KLM somewhere around the middle of the European airline range on ATK per employee, but in the lower half on revenue per employee. In spite of the gains in these indicators, this suggests room for further improvement.

KLM Group revenue per employee (EUR, left hand axis) and KLM Company ATK per employee (right hand axis): FY2005 to 2013

Cost cutting is needed to avoid "a negative spiral"

The current cost savings programme is vital to reverse the trend of costs outpacing revenues and to attempt to restore the structurally higher levels of profit that KLM enjoyed before the crisis. Its slender profit margins are being eroded, leaving no breathing space in the event of another downturn in demand.

KLM's unit revenues recovered well from the global recession, but it is now a challenge to grow them further, particularly given already very high load factors. This further sharpens the focus on unit costs, particularly in the context of Air France-KLM's Perform 2020 target to reduce Group unit costs by between 1% and 1.5% pa.

As KLM CEO Pieter Elbers put it: "It has to be quicker, more flexible, easier and cheaper to provide the rapidly growing competition and to invest in fleet and product innovation. We take action where necessary. If we do nothing, we will get into a negative spiral." (AFP/De Telegraaf/Het Parool, 27-Nov-2014).