AFLYY - Air France-KLM: Can The Business Hit 7% EBIT Margin This Year?

2023-05-15 18:22:58 ET

Summary

• AFLYY's goal of achieving a 7% EBIT margin in FY23 is crucial for valuation rerating.
• Falling fuel costs and increasing yields provide an opportunity for a strong margin performance this year, but controlling non-fuel expenses and overcoming recent cost increases are challenges.
• Given the uncertainties and challenges, I recommend a hold rating while monitoring performance and gaining more clarity on FY23 performance.

Investment thesis

Air France-KLM ( AFLYY ) primarily operates as an airline under the brand Air France. The company's stock was heavily decimated during covid due to the restrictions in travel and domestic lockdowns, and EBITDA was went from EUR4.2 billion to -EUR1.7 billion. All these are now done and dusted, and things are gradually improving. While I believe air travel is going to continue growing as GDP/capita increases and the world becomes more connected, my focus for AFLYY stock is in the near-term. In my opinion, the stock's lackluster performance so far is due to the lack of visibility into FY23 performance, which to be fair is a very difficult environment - high inflation impacted leisure travel, and high rates are impacting valuation. The former impacts the business, while the latter impacts the stock. As such, I recommend to stay on the side lines for the stock until we gain more clarity into FY23 performance (most likely after 2Q results as we can hear comments about the summer travel trends).

1Q23 results

AFLYY reported an operating loss of -€306 million in 1Q23, which represents a slightly larger loss than consensus estimates of -€294. During this period, AF KLM generated revenues of €6.33 billion, which were relatively in line with consensus estimate of €6.32 billion. In terms of network capacity, AFLYY flew approximately 89% of the capacity levels recorded in 2019. Additionally, unit revenue exceeded 2019 levels by around 19% while group non-fuel unit costs remained relatively in line with the levels observed in 2019. As for cargo yields, it came in at approximately 61% of 2019 levels in 1Q23, which was disappointing as it declined from 190% in 4Q22.

Margin

One of the most important questions regarding AFLYY's business and stock is, in my opinion, when the company will achieve its goal of a 7% EBIT margin. Since a significant cost component-fuel-is now falling, I think there is a good chance that this will occur in FY23. This combined with an increasing yield (which is likely to continue as travel recovery picks up), could lead to a very strong FY23 margin and in-turn earnings. Although management is typically reserved when discussing forward yields, they have hinted that things will look up in the coming quarters thanks to rising demand from the leisure and long-haul sectors. Without a major economic downturn or another global pandemic, these factors should allow for an EBIT margin of 7%. However, this is no simple task, as it requires the current fuel cost dynamics to persist, as well as successful execution on ex-fuel unit costs and sustained increases in yields for the remainder of the year. It will be difficult to control non-fuel expenses, I should add. The most recent quarterly results indicate that the cost per available seat kilometer [CASK] excluding fuel has surpassed the levels seen before the Covid-19 pandemic. While the group still has additional capacity to recover as it remains below the levels recorded in 2019 during 1Q23, the business needs to get past the cost headwind from the recent CLA increases at both Air France and KLM. However, if successfully pulled off, I believe the stock will gain a huge positive momentum as the current expected timeline is between 2024 and 2026, and consensus seems to be expecting this to happen in 2026.

Valuation

AFLYY used to trade at around 8x forward EBIT and is now trading at 6x forward EBIT. As previously stated, the key catalyst is whether AFLYY can achieve 7% EBIT margin this year; if it does, I expect valuation to rerate positively almost immediately as consensus will pull forward their modelled numbers, resulting in massive earnings revisions. Given the company's capital structure (EUR7 billion in net debt, or nearly twice the market cap), the 2x increase in multiple will have a significant impact on equity value. If we use the consensus revenue figure for FY23, the upside from the current share price is very appealing.

I'd also like to point out that even if AFLYY achieves the consensus estimate of 7% EBIT margin in FY26, the upside is still very appealing. Importantly, the returns will most likely be front-loaded, as expectations of AFLYY hitting 7% margins and returning to a normalized environment will put a positive spin on the stock.

Risks

If AFLYY can't increase capacity to help bring down ex-fuel unit costs through 2023, then the 7% margin goal for FY23 will be in jeopardy. This should not be an issue for the long-term, but if it becomes one, then valuation will likely be structurally impaired.

Conclusion

In conclusion, AFLYY's stock performance has been lackluster due to limited visibility into FY23 performance in a challenging environment with high inflation and valuation concerns. Achieving a 7% EBIT margin in FY23 is a key catalyst for strong performance this year, and while there are positive indicators such as falling fuel costs and increasing yields, controlling non-fuel expenses and overcoming recent cost increases are key challenges. As such, I am recommending a hold rating while monitoring performance and gaining clarity on FY23 performance.

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