In May of this year Air France-KLM Group (Euronext: AF) piqued our interest as a potential short candidate. We decided to run it to ground, so to speak, and ultimately include it in our model portfolio ahead of the official launch of Montaka on July 1st. The case study of Air France-KLM provides a real life demonstration of both Montaka’s research process and short assessment framework taking off.
Air France-KLM first came to us when the Montaka research team’s collective industry knowledge combined with our broad coverage of global news events and pointed to chronic problems for the Franco-Dutch carrier. Coincidentally this human insight was reinforced by the results of our proprietary fundamental model – the machine ranked Air France-KLM in the second last decile of potentially attractive long investments – so we decided to commit some human sweat to the opportunity. Let’s explore the case further.
Air France-KLM is the result of a merger in 2004 between Air France, the French national flag-carrier, and KLM, the Dutch airline. In 2014 the combined company was Europe’s 2nd largest airline, behind Lufthansa Group, carrying 87 million passengers to 316 destinations in 115 countries. In mid May 2015 the stock price of Air France-KLM was above €8 per share, representing an equity market capitalisation of €2.4 billion and a total enterprise value of almost €14 billion (including capitalized operating lease obligations).
Despite impressive size and scope, Air France-KLM has been just as guilty of destroying shareholder capital as the next airline. Our analysis of the company’s financial history revealed that the economics of Air-France KLM’s business have been woeful. Profitability was difficult to achieve over the last 4 years and return on capital over this period was consequently negligible – indeed some years it was negative. In 2014 net profit and free cash flow (operating cash flows less capital expenditures) were both negative even as the price of oil declined, and the book value of equity was also negative by the end of the year. Worse still it appeared to us that any improvement would be highly unlikely because Air France-KLM faces permanent structural challenges.
While Air France-KLM’s operations include passenger flights, cargo freight, maintenance work and other services, the passenger business is the key value driver. Passenger flights generated revenues of €20 billion in 2014 and represented 80% of overall group revenues. Yet Air France-KLM’s passenger business faces intense competition on two fronts.
In Europe low cost carriers (“LCCs”) such as Ryanair and easyJet have gained share since the liberalisation of air traffic regulations in the 1990s. These airlines have become the 3rd and 5th largest in Europe by offering budget fares to travellers underpinned by new fuel-efficient aircraft, convenient point-to-point routes and flexible contracts with employees.
Internationally, pressure is coming from carriers from the Persian Gulf, including Emirates, Etihad and Qatar Airways. Over the past decade these “Gulf carriers” have continued to add capacity and capture share on direct routes from Europe to the Middle East, as well as indirect routes from Europe to Asia which connect through Gulf hubs. The Gulf carriers have added capacity at 5x the rate of Air France-KLM’s growth in recent years and offer premium services at competitive fares. Uneconomic routes are subsidised by the Gulf governments who own the airlines and view increased inbound air traffic as strategically important to the prosperity of their states.
To remain viable in this environment Air France-KLM must operate more efficiently. However the company is burdened with an elevated cost structure driven by rigid contracts with its highly unionised labour force of pilots, cabin crew and ground staff. Efforts by management to contain salary and pension costs, which represent 50% of the airline’s cost base, are typically met with disruptive strike action. Over a 2-week period in 2014 strikes by Air France pilots cost the company €425 million. We believe employee resistance will continue to act as a handicap on Air France-KLM achieving a competitive cost base. At the same time competitors continue to improve their cost positions, raising the bar for improved cost outcomes even higher for Air France-KLM.
To make matters worse, we believe that the French Government’s sizable shareholding in the company further marginalizes the likelihood of management effecting change for the benefit of shareholders. In fact the government intends to apply its Florange Law which would double the voting power of its almost-20% stake and in our view ensures that employees are taken care of ahead of shareholders. We believe that the market often overlooks the intent of the French government, as Air France-KLM’s largest shareholder, to support social policy to the detriment of the company’s equity value.
Against this industry backdrop and in the context of a weak economic situation in Europe, we believe that market expectations for sales and margins appear unreasonably optimistic. Sellside consensus expectations imply low single digit average annual sales growth for the next 4 years and EBITDA margin increasing from 8% to a record 12% over the same period. These forecasts for growth in profitability reflect the market’s confidence in management being able to reduce labour costs and take advantage of a weaker oil price. Our “divergent expectation” is that any cost relief will be slow to emerge, limited by a strong US dollar and ultimately competed away. An improvement in earnings will likely be difficult to achieve.
The risks facing Air France-KLM are not confined to operational issues. The company carries €5.4 billion of net debt on the balance sheet, but this is only part of the story. Air France-KLM also leases a portion of its aircraft fleet which results in financial obligations that are not recorded on the balance sheet but are akin to debt. Adjusting for the value of these leases increases the effective net debt to €11.5 billion and equates to 4x earnings before deducting capital expenditures required to maintain the existing fleet. But there is still more. Air France-KLM’s pension obligations to its employees (past and present) currently exceed pension plan assets by around €700 million. While this is not a non-trivial amount in and of itself it is just the tip of a potential off-balance sheet iceberg. The gross value of pension commitments total almost €17 billion and increased by €4bn in 2014 alone as low interest rates raised the cost of funding retired employees. We believe Air France-KLM’s combined financial obligations represent a major risk to shareholder value which lurk just beneath the surface.
As a result of our extensive research we determined that Air-France KLM met the criteria of all four categories that comprise our unique short framework, and we added it to the model short portfolio at around €8 per share.
Since May Air France-KLM’s situation has weakened on balance. In June the airline’s management announced a step up in its previously announced restructuring program as employee costs continued to rise. The announced actions included dropping unprofitable routes, reducing frequency on others and delaying delivery of new long-haul aircraft. Management also reported traffic figures for the month of June. Passenger traffic unit revenues at core Air France and KLM airlines were up only slightly compared to 2014, however the revenue measure was noted to be “clearly” down when adjusted for foreign currency movements.
At the same time jostling with pilot unions continues. Notably in early July management reached an agreement with KLM’s pilot union to freeze salary increases among other measures, in line with its cost saving strategy. However, the agreement still requires approval of union members. Separate negotiations with Air France pilots are ongoing even as the important European summer vacation period goes into full swing.
Air-France KLM’s stock price has responded by depreciating more than 20% in almost 2 months. The shares currently trade just above €6 after rebounding from a 12-month low of €5.85. While the short thesis was much more attractive at a share price of €8, we still believe there is more downside potential for the equity from here and maintain a small short position in the Montaka Global Fund.