Air France-KLM is working with the Apollo Global Management fund to inject 1.5 billion euros into a new subsidiary to manage the Flying Blue program. This is a common occurrence in other countries, but it needs to be explained in the specific case of Air France-KLM.
Air France-KLM will transfer the management of its Flying Blue frequent flyer program to a new entity which will “own the Flying Blue frequent flyer program brand and the majority of contracts with partners” and will become the sole issuer of Miles for airlines and partners. This entity will issue bonds worth 1.5 billion euros, to which the Apollo Global Management investment fund will subscribe in order to strengthen the group’s equity capital.
But why do this when Air France-KLM seems to be doing just fine?
In this article:
- Air France-KLM is performing well again… but not well enough
- The mechanism put in place by Air France-KLM to strengthen its balance sheet thanks to Flying Blue
- What’s in it for Air France-KLM and Apollo?
- Why does Air France-KLM use Flying Blue to raise money?
- The lucrative business of loyalty programs
- Why “only” 1.5 billion for Flying Blue?
- No, Air France KLM is not mortgaging Flying Blue!
- Opportunities for the future
- Bottom line
Air France-KLM is performing well again… but not well enough
All the figures for 2023 prove it: Air France-KLM is doing well, in fact very well, and like many airlines it is posting historically high profits in this post-COVID recovery period. But that’s not all: the margin has also taken a big leap forward, in line with the ambitions stated by Ben Smith on his arrival.
“Air France’s margin in 2018 was only 2 percent, compared to 9 percent for KLM, 10 percent for Lufthansa, 12 percent for British Airways and 18 percent for Ryanair. A 2% margin at Air France is not satisfactory. Five points can be explained by the costs in France. But two points are due to the complexity and inefficiency of the airline. It’s up to us to tackle it. “he said.
In the first quarter of 2023, Air France-KLM’s operating margin was 6%, then 10% in the second quarter, with Air France for once outperforming KLM. A fact rare enough to be highlighted, and one more thing to be credited to Ben Smith’s five-year tenure.
But that’s not enough. If the context is favorable and Air France KLM is taking advantage of it, so are its competitors, who are doing even better. IAG (British Airways, Iberia…) reports a margin of 16% for the same period, Lufthansa Group 12%…
Above all, however, the Group must continue to strengthen its balance sheet, which was shaken by the COVID crisis, forcing it to recapitalize in order to repay the aid received during this period. But here again, the group is much more fragile than its competitors, and this cost it the takeover of ITA, as it was unable to repay the aid received in time.
Air France-KLM must therefore continue to battle on the profitability front while continuing to strengthen its equity base so that it can continue to compete on an equal footing with its competitors (on the TAP takeover for example?). It is in this second perspective that the operation currently under discussion falls.
The mechanism put in place by Air France-KLM to strengthen its balance sheet thanks to Flying Blue
To restate in simple terms what has been explained above: Air France-KLM will create a subsidiary to operate the Flying Blue frequent flyer program. It’s important to note that this was one of the few major airlines not to have spun off its loyalty program, and this is an important subject to which we’ll return below.
This new entity will own the Flying Blue brand and contracts with suppliers, but not the database of 19 million members, which will remain the property of the Group. It is conceivable that the company will lease the operation, but will never own it, as it is an essential asset in a loyalty program.
This entity will also be the sole issuer of miles for the member airlines in the program, i.e. Air France, KLM but also Transavia, Aircalin, Kenya Airways and TAROM. It’s not neutral either, because miles aren’t free and they don’t just fall from the sky, as they have a financial counterpart. Technically speaking, when a passenger earns miles thanks to an airline, non-airline or financial (credit card) partner, this partner buys the miles from the loyalty program, which is therefore a source of revenue.
This entity will then issue bonds to which Apollo will subscribe up to 1.5 billion euros which, from an accounting point of view, will be considered as equity that will strengthen the airline’s balance sheet.
What’s in it for Air France-KLM and Apollo?
At this stage, we need to ask ourselves what the various parties stand to gain from this operation, and to do this we first need to know the conditions under which these bonds will be issued.
We are told that the conditions will be the same as those in force under the deal already signed between Air France-KLM and the investment fund, which raised 500 million euros to finance a subsidiary in charge of Air France’s engineering and maintenance activities (MRO).
These bonds bear interest at 6.9% p.a. for three years, followed by gradual increases and then a cap. Air France-KLM has the option of repaying them at any time after the third year.
So Apollo’s interest is already a guaranteed return on its investment for 3 years or even longer if Air France-KLM does not repay, which is possible because these are perpetual bonds, which means they can be considered as equity capital.
For Air Franc-KLM, the interest is to raise 1.5 billion in equity capital in a simpler way than by carrying out a capital increase, as there’s nothing to suggest that its shareholders (and in particular the French and Dutch governments) would have wanted to follow suit again after the 2.256-billion-euro capital increase in 2022, and bringing in a new shareholder is always a sensitive issue.
So, for the group, this option enables it to increase its equity capital by relying on a well-known partner, without having to open up its capital any further. From this perspective, perpetual bonds, whose funds can be considered as equity because there is no repayment obligation, were the perfect tool.
But why the loyalty program?
Why does Air France-KLM use Flying Blue to raise money?
When you want to raise money, you have to give something as a collateral. Either part of the business (shares) or pledge assets as collateral. As mentioned above, it was difficult for Air France to ask its shareholders to reinject money, and bringing in new shareholders posed other problems.
The bond system remained. But lenders never like risk, and airlines are considered risky by definition due to the very nature of their business, which makes them vulnerable to many types of risk and crisis.
And a creditor likes to know that there are assets available to repay his loan. In the event of a crisis in the sector, a fleet of aircraft is less valuable than real estate, and less easy to sell… Add to this the fact that airlines are owning less and less of their aircraft! Before the crisis, Air France owned just 40% of its fleet, and there’s nothing to say that this figure hasn’t fallen since.
Loyalty programs, on the other hand, are a highly profitable business, with little risk, so an investor will prefer to back his investment with this activity. That’s why Air France-KLM used Flying Blue as a vehicle to bring in an investor.
The lucrative business of loyalty programs
Indeed, many people think that loyalty programs are a financial burden for airlines, because the miles issued are a debt owed by customers to the airline, which is true.
But miles don’t come free either. As we said earlier, when a customer receives a mile, someone has paid for it. Airlines, credit card issuers and other partners buy the miles they offer their customers from the frequent flyer program. It’s just up to them to make sure that the transaction is profitable for them, i.e. that the amount spent on the mile purchase represents only a tiny fraction of what the customer spent with them to obtain these miles.
And it works very well: during the COVID crisis, loyalty programs helped American airlines to raise considerable amounts of money, because they are valued much higher than the airlines to which they belong, since it’s a risk-free business. In the past, some airlines have even lost money on their core business, but returned to profit thanks to their loyalty programs.
Why a risk-free business? Because even when the planes aren’t flying or are almost empty, the loyalty program continues to generate money, thanks to non-airline partners such as credit card issuers! During the COVID crisis, for example, American Express continued to spend astronomical sums on mileage purchases, as its customers continued to use their cards for everyday purchases.
But for this to work, two things have to happen: the loyalty program has to be isolated from the parent company, so that it has its own balance sheet and activities, and the business of co-branded credit cards between an issuer and an airline has to be lucrative.
Why “only” 1.5 billion for Flying Blue?
6.8 billion dollars raised by United thanks to its loyalty program, 9 by Delta, 10 billion for American Airlines, a far cry from the 1.5 billion targeted by Air France-KLM.
There are several reasons for this. Firstly, Air France-KLM has only issued bonds up to the amount of its equity needs, which have nothing to do with the needs of these airlines in the midst of the crisis.
Secondly, these programs do not have the same number of members: 19 million for Flying Blue, 115 million for AAdvantage (American Airlines), over 110 for Skymiles (Delta)…
Last but not least, their biggest non-airline revenue providers – credit card issuers – don’t have the same business model in Europe and especially in France, Flying Blue’s birthplace and its original natural catchment area, which prevents them from being as generous as they are in the United States.
Card issuers like Visa or American Express have two sources of revenue (not to mention fees, which are ridiculous compared to the sums we’re talking about).
Firstly, the interest rates charged to their members. Sometimes 20% and more in the United States, 0% in France, as these are not real credit cards but interest-free deferred debit cards.
Secondly, the interchange rate, which is the commission paid by the merchant to the issuer when the customer uses the card at the merchant’s premises. Around 2% in the USA, 0.2 to 0.3% in France.
So European customers in general and French customers in particular generate absolutely no revenue for card issuers. compared to the US customer, and the logical consequence is that the issuer will be much less generous in what it offers as part of a co-branded card (earning miles, bonus miles, status offered, a certain number of qualifying miles offered every year….). That’s as much money as they don’t spend with the loyalty program, and as a result, the program doesn’t collect. Don’t look any further for the reason why these co-branded credit cards are so unattractive in France (but if they were, we’d indirectly be paying a high price for it…).
And the fact that Flying Blue now offers such cards in countries where it’s much more lucrative doesn’t change much, since the bulk of its natural customer base is European or even French. At least in the medium term.
So in such circumstances, getting 1.5 billion is a pretty good deal.
As for the second condition, namely that Flying Blue should be an economically independent entity, this is precisely what will be achieved through this operation. To date, Air France-KLM’s loyalty program has been one of the few major programs not to have been spun off into a subsidiary, a choice that made sense given the limitations mentioned above. However, it seems that the conditions are now ripe for this step, which was optional in the past but is now essential in view of the objectives pursued.
No, Air France KLM is not mortgaging Flying Blue!
There have been reports in the media, particularly abroad, that Air France-KLM is mortgaging Flying Blue, suggesting that there is a risk of losing ownership of its frequent flyer program and associated revenues in the event of bad luck. Based on publicly available information, this is totally untrue, and this kind of fear-mongering has absolutely no basis in fact!
Let’s recall the principle of a mortgage: someone lends you money, you give something as collateral in return, and if you don’t repay your creditor seizes what you’ve given as collateral.
A very common example: you borrow to finance your personal business, you mortgage your house and if you don’t repay you lose your house. Also very common in real estate: if you don’t repay your loan, your bank seizes your house.
This is a last resort when there are insufficient guarantees to do otherwise. So when I read “Air France-KLM mortgages Flying Blue”, it suggests that the airline is in dire straits and is selling off the family jewels, much as FC Barcelona has done in another area to survive in recent years. The point of making sure that the borrower has sufficient assets is to say that he has things to sell to repay his loan, nothing more.
But that’s not the case at all!
In the case of a bond, the creditor has nothing to seize, the risk he takes being compensated by the interest rate.
If we consider the operation in question:
1°) There is no mention of Apollo acquiring a stake in the subsidiary, which is a priori 100% owned by Air France-KLM.
2°) Unlike a share, a bond carries no voting rights, so Apollo has no influence on the management of the entity concerned.
3°) If Apollo’s contribution is considered as equity, it’s because the bond is perpetual, i.e. with no fixed redemption date. In other words, Air France-KLM is not required to rederepay as long as it pays interest.
4°) As far as we know, these bonds are not convertible into capital (although this may be considered at a later date).
So just because Air France-KLM is spinning off Fying Blue doesn’t mean it will ever lose control or ownership of its frequent flyer program. The name and the contracts are transferred to the new entity, not to Apollo, and the most valuable thing, the customer database, will remain the property of the group and not of the new entity! Furthermore, from a strictly operational point of view, nothing will change.
On the contrary, it’s a cleverly engineered operation that will enable Air France-KLM to improve its balance sheet and shareholders’ equity without any risk to its assets. This is a far cry from the case of Air Canada, which sold its Aeroplan program to become a mere customer before finally buying it back several years later.
Opportunities for the future
Finally, let’s look at future opportunities. Spinning off Flying Blue has immediate benefits for Air France-KLM, but also offers opportunities for the future. And we see two in particular.
The first is to bring shareholders into the loyalty program, or even to list it on the stock exchange if, as with the airlines mentioned above, its valuation is higher than that of the airline. We even wonder whether one day it won’t be loyalty programs that buy up airlines, since they are more profitable, better valued, less likely to be the target of a hostile takeover, and more reassuring for the markets. But at this stage, this doesn’t seem to be the Group’s strategy at all.
The second is to go beyond the notion of a loyalty program, or even to free oneself from it, to position in the pure and simple miles-issuing business, whatever the program concerned, as we are currently seeing with IAG Loyalty. Instead of trying to convince other airlines to join its frequent flyer program (by the way, the British Airways and Iberia programs have not been merged, they just use the same currency, avios), the group just convinces them to use the currency issued by its dedicated subsidiary.
Moreover, when it is stated that “[la nouvelle entité] will become the sole issuer of Miles for airlines and partners”, one can only think that Air France-KLM has something similar in mind.
And if Flying Blue were to expand into markets where the co-branded credit card business is more lucrative, Flying Blue could become a real cash machine for the Group.
But that’s a subject in its own right, which we’ll cover in a separate article shortly.
Air France-KLM will turn Flying Blue into a subsidiary, enabling its partner Apollo to provide equity by subscribing to bonds issued by the new entity.
This enables it to leverage the specificity of the loyalty program business to finance itself smartly, while opening up new opportunities for the future.
And contrary to what we may have read, this in no way means that the Group is mortgaging its loyalty program – quite the contrary.