More state funds for Air France as pandemic drags on

Air France - KLM announces new fund raising measures

Back in March 2020, the French government was one of the first to come to the rescue of its flag carrier, pledging €7 billion in financial support. €4 billion came in the form of bank loans, 90% guaranteed by the state. €3 billion was a direct loan from the government. The Dutch government contributed another €3.4 billion of loans, again a mix of guarantees and a direct loan. Many people, including me, thought that this was excessive at the time. But as the pandemic has dragged on, it now looks like it will not be enough.

What was always clear was that much of these loans would need to be turned into equity somehow. The company simply had too much debt on its balance sheet. Air France - KLM’s history of poor profitability and high debt levels mean that its market capitalisation of €2.4 billion is too small to be able to raise much fresh equity directly from shareholders. So nobody was surprised when the news broke recently that the European Commission had approved a capital raising in which the French State would once more take centre stage as financier-in-chief for its flag carrier.

What’s in the plan?

There are two components to the plan. €1 billion of new money will come from an equity issue, with the French State and institutional shareholders both taking part. The €3 billion loan from the French State will be converted into a “perpetual hybrid bonds instrument”, of which more later. Let’s look at the new money first.

Detailed terms have not been announced, but the company confirmed that the Dutch State, who own 14% of the AF-KLM parent company, will not participate in the parent company capital raise. Neither will 8.8% shareholder Delta, in part due to constraints imposed by the US CARES Act.

8.8% shareholder China Eastern Airlines will participate and signalled that it intended to increase its shareholding to just below 10%. The French State also committed to keeping its shareholding below 30%. So the balance of the €1 billion they hope to raise will have to come from existing private shareholders and new institutional money. I’ve run a few numbers on how the figures might play out.

Priced to go

The new shares being issued will undoubtedly be sold at a deeply discounted price to encourage take-up. When IAG did their rights issue last year, the subscription price for the new shares was set at a 36% discount to the theoretical ex-rights price. If AF-KLM price theirs in the same way, that equates to an issue price of €2.71, a 51% discount to today’s share price.

In the figures which follow, I’ve assumed that existing private shareholders take up their rights, or sell them to other institutional shareholders who then take their place. That will raise about €0.5 billion of fresh capital. About €110m would come from China Eastern if they raise their shareholding to 9.9%. I’ve assumed that the employees who hold 3.7% of the company’s shares take up half of their entitlement, worth about €20m. That works out at €2,400 per pilot, which I reckon they can afford.

All this leaves €370m to come from the French State, which would take their shareholding to 25.6%, below the magic 30%. That suggests there is a little headroom for the French State to make up the difference if the institutional placement does not go well, or if the employees don’t fancy putting any more money at risk.

The Dutch State will be diluted to around 7.5% and Delta are likely to end up with under 5%.

What on earth is a perpetual hybrid bonds instrument?

The direct State loan of €3 billion will be converted into an exotically named “perpetual hybrid bonds instrument”. Not much detail is given on this, but it is also referred to by the name of “Super-Subordinated Notes”. That presumably means it will rank behind every other debt obligation in the event of a default. That seemed already to be true of the existing State loan which, according to the AF-KLM accounts, “is subordinated to the French State guaranteed bank loan and, in the event of receivership or liquidation, to all the Air France-KLM senior bond and bank debt”.

We also know that it is designed to count as equity for the purposes of International Accounting Standards, which is obviously the real purpose behind the change. That will make Air France’s accounts look better and go some way to restoring the negative equity of the Group, which stood at negative €5.4 billion at the end of 2020. That has more of a legal consequence in France than it does in the UK and the USA.

That must mean that there are no contractual obligations to make any coupon or principal payments, so I assume that is the main difference. The existing loan has contractual payments and redemption dates, which presumably have now become non-contractual.

I assume that the stipulation in the existing State loan that no dividends can be paid until the loan is repaid remains in place.

What does swapping the existing loan for this exotically named instrument mean in practice then? Other than earning the bankers and lawyers some more fees, of course. Not a lot, as far as I can tell. It doesn’t make much difference to the debt-holders, since they already ranked higher than the French State on a wind-up. It would allow AF-KLM to stop making payments to on the State loan, leaving more available to meet their senior debt obligations. It makes the least difference to the equity holders, who will still only ever get any dividends if the instrument and any rolled up coupons have been repaid.

The main thing that has changed is that Air France doesn’t need to make the coupon payments or repay the State loan if it doesn’t want to, or can’t. Previously, if it couldn’t make the payments, the French State could put Air France into bankruptcy by enforcing its claims.

Yeah, like that was ever going to happen.

Much more work to do

The company acknowledges that it has more work to do to improve its balance sheet. Part of that will undoubtedly come from the Dutch government doing a similar modification of the terms of the €1 billion direct loan to KLM, with an objective of turning it into something the accountants are happy to call equity. Again this won’t have much practical consequence for other creditors or ordinary shareholders.

The fact remains that ordinary shareholders will still sit at the end of a very long queue in terms of ever receiving any dividends. Net debt at the end of 2020 was €11 billion. Negative equity of €5.4 billion on the balance sheet will improve by €4 billion from reclassifying the French and Dutch state loans as quasi equity, but still leave it heavily in the red. Both net debt and book equity will benefit from €1 billion of new capital, but that is likely to be more than offset by Q1 2021 losses. The company gave guidance that operating losses in Q1 would be €1.3 billion.

Conditions imposed by the EU

The final component of this announcement was the confirmation of the conditions that have been imposed by the EU Commission in order to allow this latest bout of “State Aid”.

it was confirmed that Air France needs to give up 18 “take off and landing slots” at Paris Orly airport. That’s enough for about six aircraft’s worth of flying, assuming three round trips per day per aircraft. It is also equal to 12% of the slots that AF-KLM Group uses for European flights at the airport.

What might giving up those slots do for the company’s competitive position at the airport? It will take them from a 60% share of short-haul services from Orly to 53%, which will be painful but not fundamentally change things, especially given Air France’s broader position in the Paris market through its CDG operation.

Of more consequence is what the slot divestiture might mean in terms of strengthening the position of its competitors. The number two player at Orly is IAG, with 15% of European flights in summer 2019, mainly through the group’s low-cost arm Vueling. If IAG picked up the slots, that would take them to 22%. The other main competitor at Orly is easyJet, with 10% of European flights in 2019. If they got the slots, they could get to 17%. In either case, Air France would be facing a more meaningful competitor.

The other possibility of course is that Ryanair or Wizz might move in and my guess is that is what Air France fears most. They managed to get the EU Commission to agree that slots would only be available to a carrier that bases its aircraft and crews at Orly, rather than using cheaper foreign based crews. That won’t deter easyJet or Vueling, who already have Paris-based crew, so I think it is aimed at keeping Ryanair and Wizz out.

Where does all this leave AF-KLM?

This is clearly a positive step for the company, but the situation has deteriorated since they started the process. With the pandemic continuing to drag on and France going back into lockdown with rising case numbers, significant losses and cash burn seem likely to continue for some time, so €1 billion of fresh capital doesn’t seem anywhere near enough to me.

I think the French tax-payer had better stand by for more cash calls later in 2021.