FLUG REVUE April 2003: KLM seeks profitable alliance

KLM SEEKS NEW ALLIANCE

By Sebastian Steinke

Rob Ruijter, Chief Financial Officer and Managing Director, announced the surprising news at a press conference at the end of January that KLM was selling its no-frills subsidiary Buzz for the bargain price of Euro 24 million to – of all the airlines around – its low-cost rival Ryanair.

"Since last summer we have carefully reviewed our low-cost operations and determined that it is sub-optimal to operate two cheap fare subsidiaries [Buzz and Transavia] in the group at the same time. Merging the two subsidiaries would have been pointless, as Buzz would have needed a lot of investment. The advent of new competitors in the low-cost segment since the autumn has initiated a kind of bloodbath on the price front.”

747-400 of KLM in new livery

By disposing of Buzz, he argued, it would be possible for KLM to concentrate management activities on the fate of the core business at this difficult time. Like BA, which last year sold its no-frills subsidiary Go to easyJet, KLM is now selling its loss-making Buzz to Ryanair.

Ryanair CEO Michael O'Leary, who by his own admission had not intended to grow by acquisition, explained his latest purchase pragmatically as a pure opportunity buy, "rather like when one finds a £10 note accidentally lying in the road.”

Initially Buzz will operate some routes for Ryanair in the form of a subleasing arrangement and will not be integrated into the rest of the company. If Buzz is not making double-digit million profits within a year – and at the moment it is making losses of the same amount – O'Leary is already threatening to liquidate the entire airline. Its main value to Ryanair is probably its landing rights in London Stansted, where Buzz accounts for up to 40 percent of capacity.

However, KLM is retaining a foothold in the booming no-frills segment through Basiq Air, a low-cost brand of its chartered flight subsidiary Transavia. Basiq Air currently flies to 13 destinations in the Netherlands, France, Spain, Portugal and Italy with six of Transavia's fleet of 26 aircraft. Transavia, a 100 percent subsidiary of KLM, operates out of Amsterdam and Rotterdam with its own negotiated wage and employment agreements. For 24 years Transavia, which this year is to retire its Boeing 757's in favour of a fleet consisting entirely of 737NG's, has consistently flown at a profit.

In the comparison between Buzz and Transavia, Rob Ruijter regards the Buzz fleet as its main handicap. In his view, the BAe 146 is not a suitable a type for low-cost airline operations. A 737 on the other hand offers significantly more seat capacity. Buzz was created "on the spur of the moment” when KLM took over the British Air UK in order to exploit its routes and infrastructure. According to Ruijter, the organically grown Transavia offers significantly less risk in these times of much tougher competition.

As well as its loss-making no-frills subsidiary, KLM recently freed itself from a legacy of particularly burdensome obligations on another front. After a dispute that had lasted several years and had at times been very bitter, the Dutch have reached agreement with Alitalia in a court of arbitration regarding the cancellation of a close alliance first planned in the summer of 1999 and far-reaching corporate ties. In return for a one-off payment of up to Euro 175 million, which, however, will partly be settled through services in kind, KLM will be discharged of all its obligations to Alitalia.

Not only does this liberate KLM from an apparently irresolvable ongoing dispute with Alitalia on the use of the Milan airports of Linate and Malpensa, but it now clears the way to fresh negotiations on entry of the airline to the SkyTeam alliance owned by Air France. Ironically Alitalia has meanwhile become a member of SkyTeam as well.

The critical strategic subject of "entry into an alliance” has been at the top of KLM's wish list for some time. For the long-established airline, whose full name is Koninklijke Luchtvaart Maatschappij ("royal aviation association”) and which, having transported about 16 million passengers and 490,000 tonnes of cargo and mail in the business year 2001/2002, ranks seventh out of 260 IATA members, cannot fill its many long haul flights from the relatively small Dutch market alone.

For this reason KLM has forged a whole network of small alliances of convenience. These include Aer Lingus, Cyprus Airways, Jet Airways, Kenya Airways, Malaysia Airlines, Martinair, Northwest, Surinam Airways, Alaska Airlines, Air Europa, China Southern, Continental, CSA, Lithuanian, Maersk Air, Malev, Ukraine International, the French state railway SNCF and the railway company Thalys.

Despite this impressive list, every attempt at forging more extensive alliances in the past has failed apart from a very successful joint venture with Northwest Airlines for US routes, in which the partners share all revenue and expenditure.

The central KLM hub of Amsterdam lies geographically right in the centre of a particularly well-off, densely populated area of Europe. From here the 30,381 strong workforce of KLM serves a global network which, including codeshare flights, numbers some 400 destinations in over 80 countries.

Yet it may be precisely the scale of this network that arouses the suspicion of potential partners. As well as Alitalia, KLM has several times seriously considered an alliance with BA. Apart from the complicated situation regarding traffic rights on North Atlantic routes – BA, it will be remembered, has a co-operation agreement with American Airlines, while KLM co-operates with Northwest – the two airlines would appear theoretically well-suited, yet they have been unable to reach agreement despite several attempts. Moreover, the American Department of Transportation has threatened that if BA and KLM were to join forces it would seek to renegotiate the US traffic rights of both airlines which were thought to be secure.

KLM's obviously competing neighbour Lufthansa can probably be ruled out as a possible alliance partner, which means that the only continental alternative left to BA and Oneworld is the SkyTeam alliance centred around Air France.

This subject has recently gathered pace as a result of the latest marketing teaming agreement that has been agreed in the USA but not yet officially approved between KLM's partner of many years, Northwest, KLM's new partner Continental and SkyTeam member Delta Air Lines.

"We are talking to Oneworld and SkyTeam,” Rob Ruijter confirmed at the end of January, adding, "We have received invitations from both alliances.” On the current state of affairs, Ruijter observed, "Our negotiations with SkyTeam have been stepped up.” Oneworld might be the "natural choice” and "on the list”, but there was also a risk of losing premium traffic at Heathrow. On the other hand the SkyTeam alliance, which was at a "slightly more advanced stage” of negotiations, already has two hubs on the continent. Whichever way the decision goes, KLM's network must in any case be kept intact and secure Amsterdam's position. In view of these factors it was impossible, he said, to give a timeframe for the alliance decision. KLM would therefore not wait for corporate decisions on the alliance solution.

In the absence of an end to the complicated marriage negotiation process, KLM has embarked on a two-stage fleet renewal process. Under the first phase, some MD-11's and all the elderly 747-200's and -300's from its main supplier, Boeing, are to be replaced by ten new Boeing 777-200ER's and three 747-400ERF dedicated cargo planes, while in the second phase the remaining eight MD-11's and 12 Boeing 767-300ER's will then be replaced by additional Boeing 777-200ER's and KLM's new Airbuses, the A330-200. KLM's Chief Operating Officer, Peter Hartman, explained the Airbus decision on the occasion of its official announcement in terms of low operating costs combined with greater environmental acceptability, an important factor as regards noise emissions in Amsterdam.

For Airbus the order is particularly important in several respects. First of all, in addition to the six A330's for which firm orders were placed in November 2002, there is the prospect of further orders for up to 18 additional aircraft between 2005 and 2010. At the same time Airbus is already thinking ahead to the day when KLM retires its large fleet of 747-400's since, as Airbus Chief Commercial Officer John Leahy admitted, the prospects for the A380 may then be greater.

Despite the present uncertainty in the industry, according to Rob Ruijters KLM will in any case pursue its planned fleet renewal programme, as the new types will bring significant savings in operating costs. KLM may even accelerate the withdrawal from service of the older types.

The CFO is satisfied with his fleet's daily utilisation. The long haul planes are in the air for an average of 13 hours per day, assisted by the network structure.

On the other hand he regards the overall situation in the airline sector as difficult. Since the end of November KLM has had to contend with a fall in demand combined with rising oil prices. A lot of passengers are postponing or cancelling their trips. In particular, traffic from Asia and the USA has collapsed. Since the end of last year revenue in Europe has dropped especially sharply, by 7 percent. Freight has also been below expectations since December, although tourist traffic is standing up well.

The contest sparked off by new entrants to the low-cost sector in Germany is apparently also affecting other regions such as France and the United Kingdom. KLM will therefore concentrate more strongly on cost management. According to Ruijter, KLM has the lowest unit costs in Europe, but also the lowest revenue. The route network must therefore be kept as wide as possible. Two-thirds of fuel requirements are covered by hedging against fuel prices, i.e. advance orders at fixed prices. On the other hand wage costs have risen by 11 percent as a result of a new wage settlement. The company therefore plans to increase outsourcing, for example, in the area of information technology. Passengers need to regain confidence in travelling, Ruijter feels. In line with present trends in demand, KLM plans to reduce Business Class and offer more seats in Economy Class. Through capacity and cost control it should be possible to survive a relatively short war in the Middle East, not least as KLM has cash reserves of Euro 1.3 billion.

From page 20 of FLUG REVUE 4/2003

Last updated 4 March 2003

FLUG REVUE, Ubierstr. 83, 53173 Bonn, Germany