RealMoney Silver - Air France Is No Longer Air Chance

Air France Is No Longer Air Chance
By Vasu Vijayraghavan
RealMoney contributor
7/11/2007 3:00 PM EDT

The news that Air France-KLM (AKH) , the world's largest airline in terms of passenger-kilometers flown, was revamping its fuel-inefficient aircraft in a major way should have come as no surprise. Things have changed a lot for this airline long considered a bastion of inefficiency and French snobbery.

Last year, the airline carried more than 6.3 million passengers internationally and registered 112 billion passenger-kilometers.

Air France is still a somewhat socialist airline in that it is 11% employee-owned and 18% owned by the French state. Nevertheless, fiscal 2007 operating profits rose by 33%. And because revenue increased by 7.6%, the results are a testimony to the cost-containment abilities of this European air carrier.

The company is confident enough that this trend will continue that it has decided to go on a buying spree, ordering 30 Airbus A320s, two Airbus A380 superjumbos and 18 Boeing (BA) 777 wide-body twin engines.

The price tag of $7.2 billion for the complete package makes sense on several grounds. The B777's addition to the fleet is slated to reduce Air France's CO2 emissions by 23% to 28% between 2006 and 2012 and, more importantly, will help contain airline fuel costs, which increased by 18.7%, or an estimated 235 million euros, last year.

Additionally, Air France has cash on hand to the tune of 5.6 billion euros and has lowered its debt-to-capitalization ratio to 0.45 from 0.64, giving it the means to invest in a renewed fleet and improve its service both in terms of price and quality.

Although operating margins are still low at 5.4%, they did increase by 100 basis points from 2006 levels. By contrast, operating margins at a major U.S. carrier like US Airways (LCC) decreased year over year to 4.2% from 4.8%. After years being the butt of a joke -- "Air France is Air Chance!" -- the French airline seems to be coming into clover. The stock's three-year and five-year returns were 49% and 114%, respectively.

The 2007 dividend yield is anticipated to be 1.5%. The chart below shows that Air France stock had a strong run-up between the middle and end of 2006, and has stabilized in the $40 to $50 range this year. I don't anticipate the same steep increase over the next six months as last year, nevertheless, I think that the stock will appreciate at least 20% over the next six months to the $60 to $65 range.

AKH Stock Price
Air France-KLM

Source: 2007 annual reports for Air France

Load Factors High in All Geographic Regions

The good news for AKH seems to extend to every geographic region. The company is negotiating with China Southern (ZNH) for a joint venture in China. The latest earnings release for fiscal 2007 documents high load factors (percentage of available seat miles that are filled).

AKH Load Factors Air France-KLM
AKH	Load factors
Total passenger	79.10%
European passenger	70.80%
Americas passenger	85.50%
Asia/Pacific passenger	82.80%
Africa/Middle East passenger	71.50%
Caribbean/Indian Ocean	80.60%
Total cargo	66.30%
Source: 2007 annual reports for Air France

As well, Air France reported an increase of net profit per available seat kilometer, or ASK, of 3.8 cents per ASK between 2006 and 2007. Unit revenue per available seat kilometer was 9.9 cents per ASK for Air France-KLM (at an exchange rate of $1.40/euro) vs. 6.6 cents per ASK for a company such as Continental (CAL) .

AKH's cargo segment fared less well, since net profits per average ton kilometer, or ATK, declined to 67 cents per ATK in 2007 compared to $1.58 per ATK in 2006; cargo revenue constituted 14% of total revenue for the airline. In terms of revenue ton kilometers in cargo, Air France ranked seventh in the world in 2006, according to IATA airline rankings.

Regarding the more important metric of net profit per passenger ASK, this value widened dramatically between its 2006 level of 53 cents per ASK to $2.25 per ASK. Net profit per ASK is one of the more important profitability metrics in the airline industry, and I believe that, abstracting from the costs of fleet renewal, Air France will continue to see positive results in this area.

Other good news for AKH was the increase in free cash flow to 632 million euros, while net debt declined to 3.59 billion euros, representing a debt-to-capitalization ratio of 43%. The current ratio, at 1.03, declined a tad from the 2006 level of 1.05. Net pension assets stood at 710 million euros and the value of flight equipment increased slightly to 11.5 billion euros. More importantly, the gross debt-to-capitalization ratio declined from 1.16 in 2006 to 1.01 in 2007, which represents real evidence of belt-tightening. This should reassure investors concerned about future interest costs decreasing earnings.

A Decline in Operating Leases

One important issue for an airline is the proportion of aircrafts that it leases and the relative ratios of operating to financing leases.

Operating leases do not deliver the aircraft to the company at the end of the lease period, since they represent a rental of the aircraft. On the other hand, a notable advantage to operating leases is that depreciation is not deducted under an operating lease and is an advantage in case the company wishes to rotate its aircraft frequently, as is the case for AKH this year. As well, aircraft under operating leases are not considered liabilities to the company.

When Air France merged with KLM, it merged the aircraft as well; Air France carries only 4.6% of its aircraft as financing leases, while KLM carries 45% of its aircraft in that capacity. Wholly owned aircraft represent 63% and 23.5%, respectively, of the total number of aircraft. For the combined fleet, operating leased and wholly owned aircraft represent 76% of the total fleet. On the whole, AKH will be less top-heavy with liabilities as a result of its lease structure.

The dead hand of the state of France still counts for a high shareholder presence, which is inimical to cost-savings and efficiency for a company such as Air France. As well, while between 2006 and 2007 revenue in the Europe/North Africa segment increased by 8.7%, the 3.5% revenue increase in the crucial Asia/New Caledonia region was more disappointing. Additionally, while Air France has a dominating presence in the European region, its position could be undercut by inroads from RyanAir (RYAAY) or Virgin Atlantic -- this route being especially competitive, and providing 68% of AKH's revenue, especially crucial to AKH's future profits.

Finally, cost-containment will prove to be especially important for future earnings. The overall rate of expense growth declined to 8% in 2007 compared to the 14% increase over 2006. But increases in aircraft fuel costs, which increased by 19% over 2007, will weigh especially on future earnings.

Air France-KLM has miles to go yet to reduce costs and increase efficiency, but it has come a long way, mon cher.