Air France valuation lures buyers where many fear to go

Bloomberg

Even by the cut-throat standards of the aviation industry, Air France-KLM Group has been a dire case: labor fights that have turned violent, cost-cutting efforts blocked by politicians, low-cost carriers aggressively taking over its home market. Yet more investors are starting to buy in.
The arrival in July of new Chief Executive Officer Jean-Marc Janaillac, who promises a conciliatory approach toward labor, won the attention ofRoche-Brune Asset Management, for example. Air France-KLM made progress on cost-cutting under the previous CEO, and further restructuring can be achieved now, according to the firm, which bought almost 600,000 shares over the summer. With the stock at an “absurd” 3.1 times estimated earnings, the lowest among the world’s top 10 airlines, any progress is bound to boost the shares, according to the Paris-based firm.
“We played the change of management in deciding to invest,” Roche-Brune’s Gregoire Laverne said in an interview. “Yes, the labor situation is challenging, and it’s been tough to sort the conflicts and bring the airline into the modern era, but Air France has its back to the wall, and we think the path is set for the company to make profits again.”
Laverne is among a small band of fund managers making that bet. Javier Rillo in Zaragoza, Spain, snapped up 950,000 Air France shares for his Ibercaja Alpha FI fund over the summer, while Investors TFI SA in Warsaw added more than 280,000 shares. Even some skeptics are paring their positions: London-based hedge fund Arrowgrass Capital Partners LLP bought 1.2 million shares to cover most of its short position, according to data compiled by Bloomberg.
The shares aren’t for the faint of heart. For one thing, the competitive landscape is fierce. Long-haul routes operated by Air France and its Dutch sister, KLM, suffer from expansionist Gulf-region carriers including Emirates taking market share on flights to the Indian sub-continent and Asia. Closer to home, low-cost carriers including EasyJet Plc and Ryanair Holdings Plc have walloped Air France on domestic and European routes. And a series of terrorist attacks in France have hit the leisure business, putting pressure on fares.
Then there’s the labor strife at the French unit. Worker-management relations have always been fractious, but the nadir came in October, when disgruntled workers tore the shirts from the backs of two senior executives. When then-CEO Alexandre de Juniac sought in 2014 to create a new low-cost operation based outside France, pilots struck, crippling flights for two weeks. They returned to work after the government, owner of an 18 percent stake, backed down, catching management by surprise.

Pilot Strike
In June this year, Air France pilots struck for four days just as fans were descending upon France to attend the 2016 European soccer championship, costing the airline 30 million euros. Flight attendants, whose contract expires in October, were the first employees to strike on Janaillac’s watch, with a seven-day walkout in July that affected 180,000 passengers and cost the airline 90 million euros. Talks are still on for a new contract.
The French state’s role also dissuades some investors. The government has backed down before in the face of strikes, and will fear any upheaval in the run-up to presidential elections in May. Janaillac was a classmate of President Francois Hollande at France’s prestigious Ecole
Nationale d’Administration.
Still, the stock price reflects those risks, according to Laverne. Air France closed Thursday at 4.84 euros a share, giving the company a market value of 1.45 billion euros ($1.6 billion). The stock is down 31 percent this year and has lost almost two thirds of its value since the carrier’s 1999 IPO. Air France-KLM remains Europe’s biggest airline by traffic, yet has a market value just one-seventh that of British Airways owner IAG SA, the No. 2.

Air France-KLM is already showing the best capacity discipline and cost management of the five largest European airlines, said Mark Manduca, an analyst at Bank of America Merrill Lynch. Capacity, which measures the number of available seats multiplied by the number of miles flown, rose only 0.3 percent at Air France-KLM in the first eight months of the year, compared with 3.8 percent at Germany’s Deutsche Lufthansa AG.
Janaillac laid out his vision, which includes the motto “Trust Together,” over dinner with analysts on Monday, said Manduca, which shows a management team “that knows they are in a struggle.” He recommends buying the shares.
Roche-Brun’s Laverne says he’s willing to be patient, and believes workers are ready to come around to recognizing the airline’s plight.
“It’ll be a long road,” he says. “Two or three years ago, we would not have invested, but today we see signs that show progress is possible. We’ll profit from further possible drops in the share price to build our position so we can benefit from the potential.”