Air France's proposed merger with KLM has been billed as an historic achievement but the biggest challenge now facing the new group is likely to be justifying the business logic

Air France's effective takeover of Dutch flag carrier KLM has been hailed as the start of a much needed consolidation within the European, and for that matter, global, airline industry. Jean-Cyril Spinetta, Air France president, hailed the deal as a 'milestone' that will create 'the first European airline group'.

There is no doubt that the combined forces of two of Europe's top four flag carriers will provide the combined group, to be named Air France-KLM, with scale. Together, the two carriers have a turnover of over $19 billion, making Air France-KLM the world's largest airline group by revenues, and fourth largest by passenger volumes.

It is also a boost for SkyTeam, which will leapfrog over oneworld and will be giving the Star alliance a run for its money in terms of volumes - presuming that Northwest and Continental Airlines also come on board.

The complexities of merging these different bilateral and alliance relationships is clearly a challenge, as is the task of proving that the merger makes good business sense.

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Air France paid the equivalent of €784 million ($914 million) for KLM, through a complex share swap which will effectively see the privatisation of the French flag carrier. That will dilute the French government's shareholding from 54% to 44%. Other Air France investors will hold 37%, with the remaining 19% of the combined group held by KLM shareholders. The terms of the deal still represent a significant premium of some 40% above the closing price of KLM stock on 29 September when the deal was announced. The financial community has given the deal a cautious reception.

Analysts are quick to point out that British Airways, which was also potentially in the running for the deal, would almost certainly never have signed on the same price or conditions accepted by Air France. With the government as its major shareholder, they argue, the French flag carrier could take a longer-term view of the deal's economics. 'Other carriers may not be tempted to follow this example because they are under more pressure to deliver short-term earnings growth,' says Chris Avery, aviation analyst at JP Morgan, hinting at some of the uncertainties that investors are pricing into the deal.

The two carriers estimate that they will generate annual savings of around €385-495 million by the fifth year of their merger. However, this translates into a relatively modest 2-3% cut in the group's combined €19 billion cost base.

The reassurances that Air France has had to make to win the deal will clearly restrict its room for manoeuvre over the medium term. It has told unions on both sides that there will be no compulsory redundancies, except in exceptional circumstances, such as a repeat of the 11 September. Avery warns that Air France management 'would cause industrial chaos' if it backtracked on these promises at a later date. Air France pilots have already been rattling their sabres as they cast a suspicious eye over what they see as KLM's lower labour costs.

The Dutch state has also been promised that Amsterdam Schiphol's status as an international hub will not be downgraded over the next eight years, with KLM retaining its own operating licence, air transport certificate and traffic rights. KLM itself has won a five-year agreement guaranteeing 'fair long-term development' of long- and medium-haul services between the Amsterdam and Paris hubs. The KLM brand and logo will also be protected for the five-year period, with a promise not to favour French employees in building the new management team. Both maintenance operations are also to be maintained on an equal basis over the medium term.

So, in the immediate future, the opportunities for savings are likely to look more like alliance benefits, centring on co-ordinating sales activities, stronger negotiation positions with third parties and joint purchasing of spare parts. Converging IT applications is seen as another saving, although this may mean considerable investment.

Cost focus

Analysts worry that even these relatively modest gains will divert management attention at a time when rivals Lufthansa and BA are tightly focused on reducing their cost bases. On that front, the combined Air France-KLM still has some work to ahead. Although Air France has stayed in profit throughout the current downturn, KLM's net losses over the past two years would have pushed the combined group into the red With KLM's restructuring now well underway, and part paid for by a heavy charge in 2002, it plans to be back at breakeven this year. Even so, the two companies are not expected to show anything by way of significant profits for 2003.

Taking KLM on board may also mean that Air France's efforts to forge a closer joint venture with Alitalia will have to take a back seat. The new group has made clear that the Italian flag carrier will have to be privatised before it can join them.

Perhaps the strongest arguments put forward for the merger centre on the sheer scale that it brings. The new group would hold over 15% of the intra-European passenger market, moving ahead of Lufthansa and BA. The SkyTeam alliance also stands to gain, with the potential of bringing both Continental and KLM's long-standing US partner Northwest into the alliance. Both are already tied with SkyTeam founder Delta Air Lines in their own three-way alliance.

Continental says it sees itself integrating into SkyTeam along with Air France and KLM by the third quarter of 2004. Northwest is not certain it will move quite as quickly. Northwest president Doug Steenland says in a statement: 'The Northwest/KLM joint venture will operate on a 'business as usual' basis and will continue to compete, as it does now, against the Air France/Delta alliance.'

The Northwest/KLM agreement, reached in 1997 and covering 10 years, anticipated that the airlines would form domestic alliances. Northwest does expect to be invited 'in the near future' to join the SkyTeam airline alliance, and would join when invited.

So far, the merger and its alliance implications appear to have won a sympathetic hearing from regulators on both sides of the Atlantic. However, the complexity of effectively tying together two global alliances is new ground for both Brussels and Washington.

The Air France-KLM deal itself can expect a relatively quick response from Brussels. As a merger, rather than an alliance, there will be a clear timescale for the approval process. The initial investigation lasts one month after notification of the deal, or six weeks if remedies are called. If Brussels decides that further investigation is then needed, the time limit is extended to four months.

Early approvalThis means it is possible that the deal could be cleared before the end of the year and would be complete by the first half of 2004 at the latest. The two sides have been in 'pre-notification' negotiations with the European Commission (EC) in the run up to the investigation, ironing out potential stumbling blocks.Geert Goeteyn, partner at law firm Howrey Simon Arnold & White, says that when Brussels looked at the proposed takeover of US Airways by United Airlines in 2001, it looked at some indirect routes where there were more than 30,000 passengers a year or where would be a significant increase in market share. Brussels decided there was no need for additional remedies.

The merger has also had to steer around the thorny issue of traffic rights, allowing KLM to fly under Dutch bilaterals despite majority French ownership. To tackle this issue, the new group has been structured in such a way that 51% of voting interests in KLM will be held by the Dutch state and two Dutch foundations for a transitionary period of three years, or more if required.

By this stage, the climate of international aviation relations may well have changed enough to enable a full merger to take place. The ruling from the European Court of Justice (ECJ) last year obliges member states to remove nationality clauses in bilateral treaties with countries outside the European Union. While the talks between Brussels and Washington over a new transatlantic deal have taken centre stage, EC officials make it clear that discussions are taking place in parallel with other states.

However, Brussels insiders warn that Russia and Japan may be the most resistant to the Air France-KLM voting rights compromise. Russia has a history of using bilateral aviation issues in its horsetrading with the EC, they warn, while Japan may be hesitant to take down barriers that protect its home carriers. Both are high on the EC's target list for bilateral negotiations.

Despite some possible questions about KLM's nationality, US approval is likely, says Kenneth Button, professor at the school of public policy, George Mason University, USA.

However, the alliance implications inherent in the Air France-KLM merger are expected to re-ignite the long-running debate over whether American Airlines and BA can finally seal antitrust immunity. Washington insiders acknowledge that they may have to look again at just what they will have to give the oneworld partners in the light of any ambitious expansion of SkyTeam. American has antitrust immunity with Swiss, which is now entering oneworld after striking its deal with BA, but the US carrier is unlikely to settle for that as a fair balance for any Air France moves.

Andrew Cahn, director of government and industry affairs at BA, makes it clear that he wants to see the regulators look at the wider network implications of a grand SkyTeam expansion, rather than focus on hub-to-hub market share. He says that, with talks between Brussels and Washington on a transatlantic bilateral deal in their early stages, BA and American have no immediate plans to file for antitrust immunity. However, he says that the Air France-KLM 'is another argument that BA-American is not going to be anti-competitive'.

It could be the wider regulatory issues that the Air France-KLM deal unleashes that ultimately have the most profound impact on an airline world already heading towards liberalisation.


Source: Airline Business