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Air France-KLM's new plan to grow LCC Transavia has taken too long; a union confrontation looms

At its recent Investor Day, Air France-KLM gave details of its 'Perform 2020' five-year industrial plan, originally outlined in Jul-2014. Much of it is a continuation of 'Transform 2015': discipline over capacity and capital, further unit cost reduction (at 1% to 1.5% pa) and further balance sheet fixing. It also involves more restructuring of the short and medium haul passenger business, including a more aggressive expansion of LCC Transavia from 44 aircraft this summer to 100 in 2017, a further cuts in the full freighter fleet and growth in the more profitable maintenance business.

Perform 2020 moves Air France-KLM in the right direction, but the pace of change is glacial. The group's profitability lags its main rivals' as it continues to be hamstrung by legacy issues such as union power. Transavia is a genuine low-cost operator, but, since its French arm started in 2007, its total fleet has grown by 16 aircraft, close to 60%. Over the same period, the combined fleets of Ryanair, easyJet and Norwegian have more than doubled, adding over 300 units. It has taken Air France-KLM far too long to wake up to its LCC's potential.

See related report: Air France-KLM: a new strategic plan awaits as 2Q marks another step on the recovery path

Air France-KLM's Perform 2020: grow EBITDAR by 8%-10% pa

Perform 2020 includes a target to improve the group's profitability sufficiently to achieve a return on capital employed (ROCE) in the region of 9% to 11% in 2017 (it was 2.9% in 2013) and to reduce financial gearing ratios.

The Group aims to grow EBITDAR (earnings before interest, tax, depreciation and rentals for operating leases) by between 8% and 10% each year to 2017. While it has avoided specifying a 2017 EBITDAR target, this implies a minimum additional EBITDAR in 2017 of EUR1 billion on top of 2013's EUR2.8 billion.

Contributions to this target are expected to come 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.

Air France-KLM EBITDAR (EUR billion) growth target to 2017

Biggest changes are in medium haul passenger business and cargo

Perhaps the most significant changes in the shape of the group will be seen in the medium haul passenger business and in the cargo segment. In the medium haul passenger business, LCC Transavia will more than double its ASKs from 2012 to 2017, while point to point ASKs will be reduced by 40% and hub connection will grow by just 5% over this period.

In the cargo division, a reduction in full freighters to just five aircraft (two at Paris and three at Amsterdam) will mean a 60% cut in ATKs carried by full freighters in 2017 compared with 2012.

Air France-KLM breakdown of passenger capacity on medium haul and cargo capacity 2012 and 2017 target

Air France-KLM's full freighter fleet will fall to five aircraft

Turning first to the cargo business, where the group has been considering the strategic options for its full freighter operations for some time, Air France-KLM has backed down from implementing the more radical solutions such as closure or outsourcing.

The cargo market is characterised by weak demand and structural overcapacity, partly as a result of the much higher belly capacity now available from the Boeing 777-300 compared with the 747-400, and partly also due to the growth of cheaper sea freight for certain products. Once acquired, a dedicated freighter represents a fixed cost, whereas passenger belly capacity is flying anyway. For many airlines, freighters are an expensive luxury.

See related report: Air cargo: structural reform urgently needed where capacity exceeds demand by over 100%

Air France-KLM cargo business operating result 2011 to 2014F*

Nevertheless, KLM CEO Camiel Eurlings argued that it was important for the Group to retain a presence full freighters as they remain effective on niche routes. In particular, he said, they are vital to the large freight forwarders that are the biggest air cargo customers, particularly to carry oversized goods and to operate on routes where belly capacity is not available or is insufficient. In addition, operating freighters allows a unit revenue advantage over those airlines that only carry belly cargo in passenger aircraft.

Having already decided to reduce the Paris freighter fleet from five in Jun-2014 to two by 2015 and the Amsterdam fleet from 13 to eight over the same time frame, Air France-KLM will now further reduce the number in Amsterdam to three by 2016. This will involve phasing out a further five MD11s. The Group will be left with five freighters.

Full freighters are projected to break even by 2017

The group's Perform 2020 plan includes a target for the full freighter business to return to breakeven by 2017, after making an operating loss of EUR110 million in 2013 (the cargo segment as a whole, including belly cargo, lost EUR200 million in 2013).

Air France-KLM cargo business: full freighter operating result to 2017

Passenger business profits are all in long haul

Turning to the passenger business, Air France-KLM's investor day presentations divided this into its sub-segments. In 2013, the long haul business accounted for almost two thirds of passenger revenues for the group and was the only profitable part of the passenger division, generating an operating profit of around EUR800 million and a margin of more than 6%.

The three sub-segments of the short/medium haul passenger business - hub feeding, point to point and leisure (Transavia) - all made operating losses in 2013.

Air France-KLM passenger business results by market segment 2013

The short/medium haul hub feeding business lost around EUR400 million in 2013, although this business should really be viewed together with the long haul operation, since it is not set up as a stand alone activity and transfer pricing policy can significantly affect the reported profits of both of these elements.

The combined result of long-haul with short and medium-haul hub feeding was a profit of approximately EUR400 million, but this represents a margin of little more than 2%.

Long haul offers growth potential for Air France-KLM

The long haul market overall offers long term growth rates in the region of 4% to 5% and this remains a key attraction. However, Air France-KLM CEO Alexandre de Juniac emphasised the importance of capacity discipline and set a target for annual capacity growth in the long haul markets of around 2% pa. Together with flat capacity in the hub feeding business and capacity cuts in the point to point markets, this will give total capacity growth for the group in the range of 1% to 1.5% pa for the years 2015 to 2017.

Air France-KLM's strategy for its passenger hub business includes fuzzy and hard-to-argue-with elements such as "increased customer focus", "upgraded product offer" and "leveraging brands and networks".

This approach includes a EUR900 million investment in cabin and other product improvements between 2015 and 2017. There will also be a greater focus on reinforcing the difference between the two main brands (Air France: "caring, high quality, pleasure". KLM: "friendly, reassuring, Dutch openness").

Long haul partnerships - especially with Asia - to increase and deepen

More interestingly, Mr de Juniac spoke of the need to develop the long haul business through partnerships, with a greater focus on Asia Pacific. The Atlantic joint venture with Delta has been in place for many years (it started in the 1990s as a joint venture between KLM and Northwest), but partnerships in Asia Pacific have not yet reached the same level of maturity.

Air France-KLM has joint ventures with China Southern and China Eastern and a codeshare agreement with Etihad.

Regarding the relationship with Etihad, Mr de Juniac said that the next step would be to "convince our partner to do a revenue sharing scheme", but he could not predict the possible time frame for such a move.

The Air France-KLM group also has partnerships, including equity stakes, with Brazil's GOL and with Kenya Airways. It is investigating further partnership opportunities.

Hub profits are set to grow

Although the Perform 2020 plan does not include a specific profit target for the hub business (at least not a public one), the group aims to improve significantly on the EUR400 million operating profit achieved in 2013.

Air France-KLM hub* operating result to 2017

Medium haul point to point is being restructured

If the hub operation is mainly looking at evolution, the medium haul point to point business of Air France is undergoing more significant restructuring.

It lost EUR220 million at the operating level, on revenues of EUR1.7 billion, in 2013. It is expected to reduce the loss to EUR140 million in 2014 as a result of capacity and staff cuts, productivity improvement, and commercial initiatives.

Air France-KLM point to point operating result by market sub-segment 2014F*

With a 77% market share on routes from Paris Orly to the French regions and a 50% market share within the regions, Air France CEO Frédéric Gagey said that, in spite of its losses, this business was of strategic importance. It gives Air France direct access to a large customer base of frequent flyers and enables it to complete its offering to corporate clients. Nevertheless, with competition from LCCs, in addition to the high speed train and other forms of surface transport such as car pooling, this is a challenging segment.

This sub-segment reduced Air France's ASKs by 9% in 2012 and a further 19% in 2013 (including the impact of the sale of CityJet). Further capacity cuts are planned for 2014 and 2015. One effect of its capacity cuts at Orly is to free up slots for use by Transavia, which is accelerating its growth (see below). Significant headcount reduction through voluntary departure plans will lead to a 14% cut in full time equivalents between 2012 and 2015, contributing to a station unit cost reduction of around 8% from 2013 to 2015.

Hop and Air France point to point organisations are to be unified

As previously announced, under Perform 2020, the point to point operations of Air France and Hop will be combined into a single business unit, although not under a single brand or subsidiary company.

Hop will remain the operator of regional aircraft, with narrow body jets still operated by Air France, but a unified organisation structure aims to increase efficiency and to increase the consistency of the two offers. Mr Gagey also said that this would "clarify the identity and scope of each brand", although he did not give further details.

There will be further reconfiguring of the point to point network, with a particular focus on secondary routes from Orly and the regional bases, where most of the losses are concentrated.

Point to point operating profit target is to break even in 2017

The new plan will also see further cost reduction, in particular station costs, which account for 40% of manageable costs in the point to point network. In addition, actions to increase unit revenue will be implemented. These will include advertising, promotional and pricing initiatives as well as operational factors such as maintaining high frequencies on its routes.

Perform 2020 aims to restore the point to point network to operating breakeven in 2017.

Air France-KLM point to point operating result to 2017

Transavia's growth to accelerate with entry into the pan-European market

The most radical, and overdue, part of the new plan involves a further acceleration of the growth of Air France-KLM's LCC brand Transavia. In addition to the fast growth already started at Paris Orly and the operation at Amsterdam, Transavia now aims to become more of a pan-European LCC by opening bases outside its two home markets. This will be achieved through a new AOC and employing local workforces.

Transavia plans to open bases at airports where it already has a presence and where LCC penetration is currently low. It is aiming for number two or three market positions, building on existing links with its home markets. Its intention is to open five to ten bases, with three to ten aircraft at each base.

Transavia's fleet will more than double by 2017

Its fleet growth will be accelerated significantly relative to that indicated at Air France-KLM's 1H2014 results presentation, when it was targeting a total of 64 aircraft in summer 2016. It is now planning for 92 aircraft in summer 2016 and 110 in summer 2017 (assuming that there are ten short term summer leases each year, as there are in summer 2014).

Transavia fleet plan (number of aircraft*) as at Jul-2014

Transavia fleet plan (number of aircraft*) as at Sep-2014

Three Transavias: Netherlands, France and Europe, but further growth in France needs union agreement

Roughly one third of the 2017 fleet will be based in Amsterdam (implying no growth from current levels), one third in France and one third in the new bases (accounting for the additional growth relative to the previous plan).

Growth of Transavia in France beyond 14 aircraft (excluding short term leases) will require the agreement of the Air France pilot union.

Given that the Air France pilots are currently seeking a unified labour contract to include pilots of aircraft of more than 110 seats at both Transavia and the mainline carrier, reaching an agreement will not be straightforward. Indeed, Air France pilots plan a strike for 15-Sep-2014 over this issue.

Mr de Juniac said that Air France pilot terms could not be applied to Transavia as "that would kill it".

He also said that, if Air France pilots do not agree to expanding Transavia France beyond 14 aircraft, he will concentrate the growth in Transavia Europe, outside the home market. The establishment of the pan-European element of Transavia is not without its challenges, but it does give Air France-KLM a useful 'Plan B' option, always important in any negotiation with unions.

Transavia's growth in France has recently been driven by the creation of routes that are new to the group. Although Air France's medium haul point to point capacity is reducing and Transavia is growing, Mr Gagey was keen to stress that there is no transfer of routes from Air France to Transavia (unlike the approach adopted by Lufthansa with Germanwings).

"We restructure what is going bad and develop what is going well", he said, with his mind clearly and understandably on the union talks.

2017 fleet plan brings it to similar levels to IAG and Lufthansa Group LCCs…

The summer 2017 Transavia fleet of 100 aircraft in the base fleet and a possible further ten or so through short term seasonal leases signals a much more ambitious use of the group's LCC than previously. On a number of occasions, CAPA has suggested that Air France-KLM's vision for its LCC was more limited than those of its European Big Three rivals IAG and Lufthansa.

See related reports:

Now, however, this 2017 fleet target would make Transavia similar to, or even slightly bigger than, IAG's Vueling, although a little smaller than the combined fleets of Vueling and Iberia Express. It would also probably make Transavia ten or 20 aircraft bigger than Lufthansa's Germanwings in 2017. Under its previous plan, the Transavia fleet would have been noticeably smaller than the LCC brands of IAG and Lufthansa.

Depending on the precise development of the narrow body fleet of the respective FSC brands of the Big Three, Air France-KLM will have approximately 40% of the group's narrow bodies operated by its LCC, a roughly similar level to that of IAG (if Iberia Express is included with Vueling under the LCC banner) and greater than that of the Lufthansa Group by perhaps ten ppts.

… but smaller than the other pan-European LCCs

Nevertheless, although Transavia's plans will bring Air France-KLM's LCC fleet to a similar level to that of IAG and to a higher level than that of Lufthansa, it will remain smaller than the other pan-European LCCs with which it will compete for passengers.

Transavia's planned fleet of 100 to 110 aircraft in summer 2017 is smaller than Norwegian's 129 to 141 at the end of 2017, easyJet's 262 and Ryanair's 388 in summer 2017. Transavia's 2017 fleet plan will see it leap-frog the aircraft numbers of Europe's smaller LCCs, but these tend to operate in more focused niche markets and not in the pan-European sphere now targeted by Transavia.

In particular, Central/Eastern Europe-focused Wizz Air plans 82 aircraft in 2017 and we expect Turkey-based Pegasus Airlines to have 67 in 2017. UK-based Monarch Airlines currently operates 37 narrow body aircraft (according to the CAPA Fleet Database) and we do not expect this number to rise significantly by 2017 (it is close to ordering 30 Boeing 737MAX aircraft, but the first will not be delivered before 2018 and the order will mainly be for replacement).

Also, Jet2.com, which operates from northern UK bases to European leisure destinations, currently has 42 narrow bodies and, while we are not aware of its fleet plan to 2017, this seems unlikely to change significantly.

Transavia is not an established pan-European brand

Transavia has another problem; it may also face challenges in establishing its brand on a wider pan-European scale. It has owned the brand, through KLM, for many years and established it in France in 2007, but has massively under-exploited it until recently.

In the meantime, others have successfully established better known pan-European LCC brands, particularly Ryanair and easyJet and also Vueling and Norwegian.

Moreover, unlike the latter four, Transavia does not have experience in managing rapid growth across many bases in several countries.

Transavia's 'hockey stick' profit projection looks extremely hopeful

A further sign of the challenge that Transavia faces can be seen in its own projection of its profitability to 2017. In the Netherlands, the main hurdles to profitability are costs and the demise of the tour operator sector, while, in France, achieving route revenue maturity will be crucial.

The challenges in the new European operation will be to establish cost efficient operations, which should be achievable by recruiting more flexible and productive labour using an AOC outside the home markets, and then achieving revenue maturity.

In 2013, Transavia posted an operating loss of EUR23 million after two years of being just below breakeven at the operating level. At the level of EBITDAR, it recorded a positive result of EUR88 million in 2014. It expects EBITDAR to be flat or slightly down in 2014 and 2015, due to the ramp-up costs of new bases, before rising rapidly from 2016.

Transavia EBITDAR target to 2017

Transavia has a target to add EUR100 million to its EBITDAR between 2014 and 2017, but the 'hockey stick' shape of the EBITDAR projection does not inspire great confidence. It will need a very significant commitment by all concerned - and that level of joint vision seems fragile at best at this stage.

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