AFRAF - Air France-KLM: Navigating For A Bright Future

2023-05-11 18:26:28 ET

Summary

• Air France-KLM SA first quarter results produced a higher than expected loss.
• Second quarter results are likely to be impacted by airplane shortages and Schiphol Airport capacity constraints.
• There could be impact on full year results, but the future looks brighter for the airline group with better harmonization on multiple levels.

Air France-KLM SA ( AFRAF ) is one of the companies that I have adopted a positive view on after being somewhat downbeat on the name in recent years due to the French and Dutch parts of the airline group not working in harmony. Initially, the buy rating paid off with a 18% return on a flat market. However, more recently all of those gains have evaporated. In this report I discuss why I think that is the case and I will explain the actual reason for the downward pressure on Air France-KLM stock. Additionally, I will discuss whether I am modifying my rating on the stock.

Airline Turnaround Materializes

Year-over-year, revenues increased by €1.884 billion, or 42%, while costs increased 43%. That is not quite the results we want to see, but EBITDA and operating results still improved by 29% and 12.5%. Overall unit revenue increased by 20% on a 20% increase in capacity resulting in 42.4% higher revenues overall. The results at Transavia were not great, with a 52% increase in revenues but a €80 million lower profit indicating an 8.5 pt contraction on the margins. Maintenance results increased by 24.4% on top line but decreased by €28 million on the bottom line. Transavia and the Maintenance segment saw €108 million lower profits offsetting a significant portion of the improvement with Air France and KLM.

Looking at the Air France and KLM businesses, one thing becomes clear, and that is that after years of KLM outperforming its French partner it is now Air France showing the better growth numbers on the top and bottom line. Air France revenues increased 46%, resulting in its is operating loss being slashed by almost 50%, while KLM booked “only” 32% higher revenues and saw its operating results going from breakeven to around negative 5% on the margin. What we are seeing is that problems on Schiphol continue to affect KLM and the problems with the Embraer ( ERJ ) E195 E2 driven by the Pratt & Whitney turbofans continue to be an issue. The results were in some way disappointing. In terms of revenues, I think Air France-KLM did well, but the operating income was underwhelming at best.

Switching to load factors, we see that total load factors increased by 11.8 pts which together with higher capacity and unit revenues drove the revenues. Premium load factors are somewhat soft but this is also an area where the group can still grow dramatically. Across the geographical regionals the load factors were strong. Interesting to note is that short and medium haul load factors are trailing and most of the capacity and load factor growth is concentrated on long haul and low-cost, though for low-cost this hasn’t really helped, as significant capacity expansion and higher load factors did not result in higher profits.

Air France-KLM Debt Profile Is Manageable

When airlines started taking on debt to survive, the big question is how effective and efficient they would be in the process of deleveraging. I think Air France-KLM did a pretty good job. They completely exited the Dutch and French state aid packages by issuing sustainability-linked bonds. Whether these bonds are just an ideal debt financing tool or will actually make material impact on “going green” remains to be seen, but it is nice to see an airline link its debt to sustainability. The airline group used €1.5 billion in liquidity and €1 billion in SLBs to exit the €2.5 billion bank loan guaranteed by the French State, which gives the group a very streamlined debt profile for the coming years. By April 2023, the company also exited the French Recapitalization State Aid, which completed the exit from all state support. The company has now reduced its net debt/EBITDA from 1.8x at the start of the year to 1.5x.

Air France-KLM Softens Capacity Outlook, Transavia Looks Problematic

The outlook for Air France-KLM has not changed much other than guiding for a softer full year for short and medium haul, which is now expected to be 80-85 percent recovered by Q2, bringing the group total 5 percentage points below a full recovery. My best guess is that capacity challenges at Schiphol continue to be problematic.

Not included in the presentations are the problems at Transavia, and I believe those are a major contributor to the downward pressure on the stock price. In April, it became clear that Transavia had to cancel 5% of its flights but that number is growing shortly before scheduled departure and that will be the case through May and June as well. The reason is actually just a lot of bad luck for Transavia. Two airplanes are out of service due to unscheduled events (lighting strike and vehicle collision), and regular maintenance events are taking longer due to the global shortage of aerospace parts. On top of that, airplanes formerly operated by Romanian Blue Air and were to be inducted in the Transavia fleet are not able to enter the fleet due to issues with the paperwork. So, it is an unfortunate combination of events that is hurting Transavia and brings Air France-KLM and its stock price some bad press.

Is Air France-KLM Stock A Buy?

The reason why I do like KLM has remained unchanged. Air France-KLM SA is seeing the benefits of its rethink on the France domestic network and associated slots, and it has improved its working rules, implementing changes that would have seen fierce resistance years ago. So, the airline used the pandemic to push through necessary changes to better position the airline. Beyond that, the cabin product and ancillary revenues have been optimized to provide more value and drive down unit costs. Air France-KLM SA has also reduced its leverage significantly.

I believe that this actually is just the start, as the airline will begin absorbing more new single aisle jets such as the Airbus A321neo. This will allow further growth from Schiphol without adding flight movements. Part of the bright prospects are dampened by the aircraft shortage at Transavia and KLM Cityhopper and the continued challenges on handling the passenger flow at Schiphol Airport.

From a fundamental perspective, significant upside remains. With €9.9 billion in enterprise value and €4.24 billion in 2023 EBITDA, the EV/EBITDA is 2.3x which is below the 2.9x median for Air France-KLM and significantly below the industry median of the industry at 8.25x. So, while there is some uncertainty on the results and Air France and KLM, I do believe that the current share prices offer around 25% upside, and the upside could easily be tenfold once the markets start seeing fleet modernization trickle through and Air France and KLM working closer together on brighter future.

Conclusion: Short-Term Challenges, But The Stock Is Priced Way Too Low

There is no denying that the second quarter results might be impacted by airplane shortages and problems on Schiphol and perhaps that provides some justification for the stock to trade lower. However, after years when Air France and KLM were basically two partners in an unhappy marriage, they are working closer together on fleet decisions, and I believe that their updated cabin product will also appeal to travelers. So, beyond the current value I see in Air France-KLM SA stock, there is a lot more once the group engages in its transformation and harmonization. The service entry of the Airbus A320neo family will be one of the most exciting elements.

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