Analysis of the British Airways and KLM merger proposals help to demonstrate why load factor is not acertain guide to profitability, writes Chris Tarry of Commerzbank.
Negotiations between British Airways and KLM may yet come to nothing, but their merger proposal already helps to highlight a crucial fact of airline life: that similar levels of traffic do not necessarily translate into similar levels of profit. The profit equation is determined, not by volume, but how appropriately a carrier's cost base is tailored to the type of traffic it carries.
BA and KLM are a case in point. Despite superficial similarities, each operates in quite different markets. Around 70% off KLM's traffic is from transfer, representing some 15 million passengers a year. The corresponding proportion for BA is only 35%, but the absolute number is also in the order of 15 million. While the overall numbers may seem similar, the implications for cost and profits are not.
A start is to look at breakeven load factors - the point at which operations start to make money. BA's breakeven is markedly lower than that of KLM (see table below right). Over the last few years the gap has reached a peak of 13 percentage points. And although KLM's overall load factor has indeed been 6-10 points higher than at BA over the same period, that does not imply that the Dutch carrier has been able to show profits from filling its seats.
A useful rule of thumb in gauging any carrier's fundamental profit potential is to look at how much operating profit is produced for each additional percentage point that its load factor rises beyond the breakeven. For example, while two carriers may both start to break even when their aircraft are half full, they will not both necessarily deliver the same level of profit as they start to climb above the 50%load factor mark.
Over the past couple of years, BA has managed to show around c165 million ($160 million) of operating profit for every point of load factor it achieves beyond breakeven (see graph). For KLM, the figure is down around c45-70. By way of comparison American Airlines generated a contribution of between $170-180.
The fact that BA has a better traffic mix than KLM has never been in doubt, nor that many of its current problems stem from losses on the shorthaul network. Even stripping out the losses from French regional Air Liberté (now finally sold)BA showed an underlying loss of over £280 million ($180 million) from its European network last year. Part of the problem has been from low yielding transfer traffic designed to feed the long haul business. In reality, the damage done to short-haul profits has more than outweighed any contribution to long haul and BA has now recognised that fact.
Some have therefore been tempted to suggest that a neat outcome from the merger talks would be to passed such traffic over to KLM. But is KLM really in a position to thrive in a transfer market, which is highly competitive by its very nature and becoming ever more so? Air France raised its premium transfer traffic last year by 24% and is well placed to pull yet more across Paris. The key to success is cost, and having a high breakeven load factor does not bode well. By definition, KLM would have to raise its actual load factors ever higher to remain in profit. However, on many of its key flights, it has very little capacity to spare. In effect all that would happen is that traffic would be redistributed elsewhere around the system. Rather, the solution is to lower the breakeven level through significant reduction in costs. And here lies both an opportunity and a threat.
Clearly there is potential for significant cost savings from a merged BA/KLM largely centred around a substantial reduction in the combined workforce. However, such cuts will come with both social and economic penalties attached. The issue then is whether those penalties will prove too high and indeed whether they can be delivered without damaging disruption to the business.
Taking a capital market perspective, there is the thorny issue of the value of these savings and how they will be shared between the two groups of shareholders. A basic factor in determining whether a transaction can be finalised is often simply for investors to ask if the "price is right". Translating that question into operational terms, the question becomes on of whether the costs are right. As ever, the fundamental of airline economics is to achieve an appropriate cost base and then to exploit it by growing the revenue line.
That in turn, will help to reassure financial markets that the proposed merger can indeed deliver the right value to BA and KLM shareholders.
Source: Airline Business
