Air France-KLM faces headwind in bid to close gulf with Middle East carriers

LONODN // For Air France-KLM, 2014 was another tough year.

The airline, combining the national carriers of France and the Netherlands, has operated since 2004. The merger created one of the world’s largest airlines but it has since struggled to maintain its position as the biggest in Europe.

In 2014, the company posted a €111 million (Dh458.6m) loss. KLM’s earnings almost halved to €175m, while Air France lost €314m. The French arm would have reported a modest €99m profit had its pilots not gone on strike in September.

Air France-KLM has significant challenges on two fronts. It is facing stiff competition from airlines from the Arabian Gulf and Asia in the long-haul international market, while its share of the European market is being eroded by low-cost airlines such as Ryanair and easyJet.

Middle East airlines have proved they can compete with European airlines on price, convenience and service.

“The development has been on the service factors. I think that the Gulf carriers have shown that they can put together value propositions that are attractive to travellers,” says Fadi Majdalani, a partner with Strategy&.

As the Gulf airlines’ networks have grown, they are now able to offer more direct flight routes to secondary cities. “On Air France-KLM and Lufthansa, the competitive environment remains challenging given significant capacity additions by the Gulf carriers in both the Europe-Middle East routes, but also indirectly by displacing connecting traffic from Paris and Frankfurt to Dubai and Abu Dhabi for passengers en route to Asia,” according to a report by JP Morgan. Still, while this represents a threat to airlines such as Air France-KLM, it may also offer them an opportunity. There have been many takeovers, stake purchases and partnership agreements signed by Gulf carriers in the aviation sector.

Etihad Airways is building up a network of minority stakes in airlines around the world as it seeks to drive traffic to its Abu Dhabi hub. In Europe, Etihad holds about a one-third stake in airberlin of Germany, a 49 per cent stake in Alitalia, the struggling Italian airline and the same in Air Serbia. It also has a stake in Ireland’s AerLingus and a 33 per cent stake in Switzerland’s regional carrier Darwin Airline, among others.

“We are bringing competition in the market. Some legacy carriers are using the European Commission to challenge us rather than challenge us through competition,” says James Hogan, the president and chief executive of Etihad Airways.

“We are open with our strategy, we can’t own or control any carrier because of bilateral, ownership rules,” he says.

Qatar Airways, meanwhile, has a stake in International Consolidated Airlines Group (IAG), the parent of British Airways, Iberia and Vueling. In addition, Gulf carriers have boosted the number of routes they ply. Etihad last month added Madrid to its network and next month will start flying to and Edinburgh, with the capitals of Georgia and Azerbaijan, Tbilisi and Baku, both arriving in October 2015. Etihad’s total number of one-way weekly seats on direct routes between Abu Dhabi and Europe was about 46,000 in December 2014, versus about 33,000 two years earlier, according to the airline analyst OAG. The other two big Gulf carriers, Emirates Airline and Qatar, have also upped flights. In 2001 both flew from 17 destinations in Europe. Now both serve 32.

The reaction of most of the established European airlines has been two-pronged — complaining and cost-cutting. One exception is IAG. It managed to slash costs at Iberia and has avoided much of the turbulence created by the Gulf carriers. Indeed IAG recently pulled out of a European trade association saying the group’s opposition to the Gulf airlines, led by AirFrance-KLM and Lufthansa, was no longer consistent with its own position.

AirFrance-KLM and Lufthansa themselves have tried to make up for years of bad management by beefing up their budget subsidiaries, Transavia and Germanwings. They have met stiff resistance from within. Pilots have gone on strike repeatedly over the past year to oppose various changes the airlines are making to become more competitive.

AirFrance-KLM has had the bumpier ride of the two. It issued three profit warnings in 2014, has shed some 7,500 jobs over three years and plans to lose another 800 employees.

“Labour costs are a huge part of the costs of an airline. European airlines will discuss this — and they have to discuss this to become more competitive,” says Rene Steinhaus, an aviation expert at A T Kearney

But, with airlines from the Middle East willing to do deals to expand in different regions, legacy airlines such as Air France-KLM have a lot to offer.

“The Middle East airlines are working on their market share in Europe,” says Mr Steinhaus.

“Qatar Airways recently bought a stake in IAG. They are clearly interested to secure market share in the London market. Etihad is also investing in several Airlines in Europe [such as] airberlin, Alitalia and Croatia Airlines. And they are also working with AirFrance-KLM.

“In my view, this is a way for them to guide traffic to their hubs in the Middle East.”

One aspect that may deter potential investors in Air France-KLM is its heavy debt burden.

“The reduction of net debt is an important objective of [the cost-reduction programme] Perform 2020,” according to the company. It has already made some progress in this area and aims to reduce its net debt to €5 billion by the end of the year.

The airline has also delayed some major expenditure, which is also helping its bottom line. KLM recently postponed the delivery of two Boeing 787s. Unlike the Gulf airlines, Air France-KLM has opted not to invest heavily in the largest aircraft.

The decision to make cuts will go a long way to improving profitability. Already, Air France-KLM has successfully trimmed its losses from €322 million in 2013 to €111m last year.

Even so, some analysts would like to see it do more. “We are concerned that new cost-cutting measures will not be enough,” says Robin Byde, a transport analyst for Cantor Fitzgerald.

It began its cost-cutting programme a couple of years ago.

However, the airline sees the Gulf as a crucial part of its future.

“Air France-KLM was one of the first to fly to this market. For Air France-KLM it is a very important market and we continue to invest here,” says Laurent Fesselier, Air France-KLM’s commercial director for the Near East, Gulf and India. “With the strong economic development of the region, the dynamics have changed drastically since we started flying to the UAE 40 years ago. From a former exclusively oil and gas driven market, we see leisure traffic growing rapidly.

Mr Fesselier has high hopes for Air France-KLM in the Middle East. “We want to be better than on a par with other airlines in the region … The Saudi Arabian, UAE, Qatari or Lebanese customer each has different wishes and expectations,” he says. “What we know for sure is that there is a high level of expected service and quality products. Customers are very demanding and have choice. If you do not to deliver, the customers will leave you.

Those are lofty ambitions. In the short-term there is a degree of pain to be managed as worsening conditions last year forced the airline to retrench further.

“The difficult economic environment and the weaker unit revenue trend developing since the summer of 2014 have … led us to implement additional unit cost reduction measures and revise down our investment plan,” says Alexandre de Juniac, the chairman and chief executive of Air France-KLM.

As part of the Perform 2020 strategy, which runs from 2015 to 2020, Air France-KLM plans to position itself as a high-end carrier and bolster its low-cost airline Transavia.

“[There are] three main growth levers: a move upmarket for our products and services, particularly in long-haul; aeronautics maintenance; and low cost with Transavia,” says Mr de Juniac.

Air France-KLM’s focus on its maintenance business, which serves the aircraft of other airlines as well as its own fleet, may already be paying off. Revenue from the maintenance unit rose 20.3 per cent in the first three months of the year on the same period in 2014.

As for Transavia, the number of passengers travelling increased by almost 12 per cent in the first quarter, but higher costs reduced Transavia’s overall profitability by 11 per cent. Over the long term, focusing on its low-cost short-haul service may drive growth. However, it could be a difficult process.

Air France-KLM’s intention to boost Transavia was the cause of the damaging pilots’ strike last year. The pilots objected to the airline’s plans to pay Transavia pilots less than those flying its standard flights.

The pilots’ strike cost the airline nearly €500m. Air France-KLM reached an agreement over the issue and can therefore continue with its expansion plans, but the threat of further strikes remains.

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