October 1, 2014 / 12:14 PM / 4 years ago

Strike-scarred Air France-KLM may need strategy rethink

PARIS (Reuters) - (This version of the story has been corrected to change cost comparisons in paragraphs seven and eight to euro cents, and not euros)

Passengers form a queue at an Air France ticketing counter at the Nice Cote d'Azur international airport in Nice, September 27, 2014. REUTERS/Patrice Masante

With no deal in sight over pilot pay and up to 300 million euros (233.54 million pounds) of strike costs to absorb, Air France-KLM (AIRF.PA) may need to rethink its route to viability.

As the airline restored its flight schedule to 98 percent on Tuesday and pilots returned to work, its estimated cost of the two-week strike represents more than double the meagre 130 million euro operating profit of Europe’s second-largest network carrier by revenue last year.

The company suffered a loss in 2012 and has not paid a dividend since 2008.

Like other traditional carriers, the Franco-Dutch group has been squeezed in its long-haul business by competition from Middle East airlines, on shorter routes by the low-cost sector, and by industry overcapacity.

But its labour cost problem is particularly acute.

Research by Barclays analysts earlier this year showed that among European airlines, only Air France-KLM and SAS (SAS.ST) had staff costs higher than their fuel costs, accounting for almost a third of total outgoings compared with around a quarter or less for other traditional players.

In addition, the research showed, Air France-KLM’s overall passenger unit cost per available seat kilometre (CASK), excluding volatile fuel costs, was the third-highest in Europe in 2012, behind SAS and Spain’s Iberia, at more than 7 euro cents.

That compares with just over 1 euro cent for the best performing low-cost player, Ryanair (RYA.I), and 2 euro cents for Vueling, the Spanish low-cost airline bought last year by the British Airways-Iberia combine IAG (ICAG.L).

COSTLY AGREEMENTS

Hence Air France-KLM’s plan to develop low-cost Transavia brand, details of which were announced in September, triggering a two-week pilots strike that grounded over half of Air France flights until the main pilot’s union called it off on Sunday.

James Halstead, a consultant at Aviation Strategy, said costly French union agreements on pay and conditions were at the root of its troubles. He and other analysts say buying a ready-made low-cost business is a possible answer.

“Air France wants to have some kind of operation that doesn’t have that sort of legacy environment ... you can see that IAG is treating Vueling as a method of providing growth in a relatively efficient way,” Halstead said.

In the meantime, the action by pilots worried Transavia will suck away jobs and erode their own pay and conditions has killed off any expansion of new Transavia hubs in lower-cost countries such as Portugal.

Analysts are already sceptical that Transavia can deliver the 100 million euros a year of extra underlying profit management is targeting by 2017. Without hubs outside France and the Netherlands, that could be harder.

Although pilots are back at work, they gave no ground on their demands for a single set of pay and conditions for both Air France and Transavia France - something management insisted last week “totally opposes the principles of this model”.

Some analysts also wonder if Air France should not retreat on domestic routes altogether, given Ryanair and easyJet already enjoy strong positions in France and want to expand there.

“There could be a lesson from British Airways, which has recognised that it cannot be all things to all people and has withdrawn from the UK domestic market other than on routes feeding the Heathrow hub,” said John Strickland, an independent aviation analyst.

Air France shares, which closed flat at 7.424 euros, have slumped from a year’s high of near 12 euros set in April. They trade on a multiple of 8.9 times prospective earnings, a discount to a peer group average of 14.4 times, according to Reuters data.

COST REDUCTIONS

Under a programme dubbed Transform 2020, Transavia was earmarked to deliver about 100 million euros a year of extra core earnings before aircraft leasing costs (EBITDAR) by 2017, or more than a quarter of the total 380 million euros targeted, by ramping up to a fleet of 100 aircraft.

The rest of Chief Executive Alexandre de Juniac’s plan involves returning the lossmaking cargo arm to breakeven and improving the profitability of its maintenance division.

Air France-KLM’s EBITDAR in 2013 was 2.77 billion euros.

But Transform 2020 also assumes an overall reduction in costs of 1 to 1.5 percent a year in order to reach a return on capital employed (ROCE) of between 9 and 11 percent by 2017, up from 2.9 percent last year.

It said it would do this partly by negotiating productivity gains with staff, a promise that looks difficult to achieve, at least where pilots are concerned.

“We refuse to let Mr. De Juniac deliver his 11 percent return at the expense of employees,” Christophe Pesenti, an Airbus A320 pilot, told Reuters at a demonstration in Paris.

Nor does full-blooded government backing for any future battle look likely, even though the Air France-KLM board, which includes representatives of 16 percent shareholder the French state, backed de Juniac’s position after his concession on Transavia Europe.

During the strike the Socialist government, faced with poll ratings and rebellious left-wing MPs, showed more desire to end the strike than to put its weight squarely behind management.

Transport Minister Alain Vidalies questioned the wisdom of the Transavia Europe venture, just a day after de Juniac had defended it at the height of the strike.

Hours later de Juniac caved in on hubs outside France, eliminating an important route for achieving possible savings.

“It is still hard to imagine Transavia can be quite as low-cost as easyJet (EZJ.L) or Ryanair, said Halstead. “Especially if they are running it from France.”

Additional reporting by Tim Hepher and Matthias Blamont; Editing by David Holmes

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