Size is not everything in the airline industry and the onus is on Air France-KLM to demonstrate that its merger brings value, writes Chris Tarry of CTAIRA
In the end, the Air France announcement that it is to acquire KLM came as little surprise. Neither did the structure of the proposed new group, which appears designed to satisfy the regulators and also enable KLM to remain in control of its destiny - at least in the medium term. But what of the likely value for shareholders?
The statements accompanying the announcement of the transaction contained the expected pledges. The merger would create 'the leading airline group in Europe'- an outcome not in doubt if physical size is the chosen measure. The combined group would have a 'dual hub strategy'- hardly a surprise given the robust line taken by KLM and the Dutch government over Amsterdam Schiphol. The transaction represented a 'major strategic step' and one that is not only expected to create 'substantial value for shareholders 'but is also in the 'best interests of customers, shareholders and employees'.
But the hard questions that even the least cynical analyst should ask centre on whether the transaction is actually likely to fulfil these promises? It is all too easy to get carried away in the apparent euphoria and believe that the merger will result in a domino effect that will spread through Europe. Here there is a need for a reality check and to examine the merger benefits in closer detail.
There is little doubt that there is tremendous value for KLM shareholders particularly if they sell up. At the time of publication KLM's share price had risen to €16.5 ($19) - almost double what it was in July and close to the indicative Air France offer price. But note that it is still some €11 less than at the time KLM held merger talks with British Airways in 2000.
The level of the Air France offer is considerably higher than any other bidder could currently have justified, given the structure of the new entity and the timing and scale of the potential benefit. For KLM shareholders though, the issue now is whether to sell out in the short term, or hold on to the mix of Air France shares and warrants. The latter would require confidence that the merger will deliver real value.
However, the undertakings that Air France has given to ensure a deal good for Schiphol and the Dutch economy in general will make it tough to unlock the deal's true potential. The real benefits from a merger in a mature market will only emerge through working to reduce cost and capacity. Otherwise, bringing two airlines together simply results in duplication.
When BA was last talking to KLM, we argued that the combined airline needed to shrink by 20% to give shareholder value. Given the overlap between Air France and KLM, with 31 common large-volume long-haul destinations, there is undoubtedly an opportunity to cut capacity and help lift yields by concentrating the traffic flows through Paris or Amsterdam rather than spreading it across the two. But that is unlikely.
Inevitably there is duplication in a number of areas where there would be scope for significant cost savings. Sales and marketing is one candidate, but the preservation of the two brands limits this. If the businesses were integrated there would also be scope to reduce the number of pilots and cabin crew too.
On most key measures of labour productivity, such as the number of flight hours per pilot or cabin crew, Air France already appears to be ahead of KLM. Admittedly some of the difference is explainable by the greater relative influence of long-haul sectors for KLM. It is also true that the Dutch carrier has a productivity lead in ticketing and sales, helped by the use of services that are provided in the USA by its transatlantic joint-venture partner Northwest Airlines. But overall it remains clear that there is room for efficiency improvements, which will be constrained by the undertakings given to KLM and the Dutch government.
Yet Air France-KLM, in common with the airline industry as a whole, needs to make a step change in productivity if it is to make a fundamental improvement in its economics and increase the attractiveness to providers of capital.
By the start of the fifth year after the transaction, Air France-KLM promises some €400-500 million in cost savings. For a business which will have some €19 billion in costs and revenues this is pitiful. Such low-level gains alone are unlikely to be enough to encourage KLM investors to stay with the merged group, which raises the question of whether there is some extra strategic advantage that this early consolidation may yield, on which the group will be able to capitalise before rivals respond. At best, such a telling strategic advantage looks uncertain. It is quite possible that a change in the rules of engagement could see their competitors overtaking them on the outside. Lufthansa in its own right has just announced plans to cut costs by €1.2 billion.
Stockbroking is often said to be about peddling dreams and the problem can be a later rendezvous with reality. Here, perhaps, the only outcome that is certain is the realisation of modest cost savings within five years and that on its own hardly appears compelling.
Source: Airline Business
