The Hindu Business Line : Air France-KLM tie-up

EARLY this month, Air France SA bought KLM Royal Dutch Airlines NV creating an airline group that will be the largest, in terms of revenues, and third biggest by passenger traffic. The deal, unveiled last September, got regulatory approvals a few months ago.

For several years, KLM's partner was Northwest Airlines. The two had joint venture on the transatlantic routes and pooled customers, revenues and so on. When Northwest won regulatory approval to ally with Delta and Continental to jointly market domestic flights, it seemed logical for NW and KLM to throw in their lot with the huge SkyTeam global alliance led by Delta and Air France. At the time there had been an offer from Oneworld, the alliance built around British Airways, American Airlines and Cathay Pacific. For KLM, SkyTeam made sense geographically as it linked the nearby Dutch, French and Italian markets but the appeal of Oneworld, as some experts observed, was "the allure of unrequited passion".

For 15 years BA and KLM flirted and therefore the link appeared logical in terms of market segmentation rather than geography. KLM would join the British carrier's lucrative point-to-point premium business traffic and, in turn, BA would have the advantage of KLM's ability to handle transfer passengers at its Amsterdam Schipol hub with lots of capacity. Locked in Heathrow, BA, it was felt, needed a Continental hub to keep growing. All this is history now.

Bilateral alliances once considered unstable latter settled down but only to pave the way for super alliances. According to a study by Boston Consulting Group, two-thirds of alliances lasted more than three years. But in 1992-95, most of them fell apart. However, several super alliances emerged. For years, the aviation industry expected most of the 200-odd international airlines to eventually consolidate into four-five mega carriers. But a ban on foreign ownership and lingering government control over routes and flights precluded international mergers.

Alliances purport to offer passengers seamless travel, with better connections, more airport lounges and frequent flyer benefits wherever they go.

One might think that reduced competition resulting from alliances leads to higher fares. Yet airlines insist that alliances actually reduce ticket prices and their claims are often backed by concrete evidence.

The reason for this is that alliance partners gain by practicing "cooperative pricing" whereby they seek to maximise the benefit to all the members. This leads to lower fare for the whole journey. Despite the merger, Air France and KLM will continue operating as separate brands and save as much as euro 500 million a year through joint purchasing and sales.

But, then, France's national carrier will have its work cut out to stem losses at its Dutch operations as well overcoming the normal post-merger problems.

More important, the Air France-KLM merger has happened at a time when the big network airlines face many challenges. These airlines were well suited for an age of regulation and state ownership. All this is passing now. Competition from budget airlines is the biggest manifestation of this change, undermining the dominance of traditional hub-and-spoke network in many regions. Online booking has made fares more transparent, and lower. The traditional network carriers are not just grappling with cyclical slump aggravated by the external shock of the past three years, but are also realising now, much to their chagrin, that the basic model is changing so much so that they must reinvent themselves or go out of business despite subsidies by the government.

In a recent study of American and European airlines, Booze Allen Hamilton pointed out that the cost advantage of the budget airlines comes from not only from having a non-unionised workforce but also from having superior and more economic business processes such as selling seats over the Internet or flying their aircraft more hours every day.

New aircraft technology is also forcing network airlines to change. The fact that the latest versions of single-aisle jets have much longer ranges than those of 10 years ago means that budget airlines can now opt for some long-haul routes in addition to the usual shorter ones.

The development of smaller 100-seater regional jets made by Brazil's Embraer or Canada's Bombardier is allowing many network carriers to substitute smaller planes on routes where the traffic volume does not always justify a bigger aircraft. Although the cost per seat is higher than that of a bigger plane, it takes fewer passengers to fill the seats and the overall trip cost is lower. There are also smaller models of regional jets coming along from the two manufacturers that could even serve to bypass the hubs.

Considering all this, a consensus is now emerging that it is time for airlines to learn lessons from the mature automobile sector marked by the presence of a handful few global players. But, then, it is also true that over the years several car-makers have been swallowed by rivals while others face extinction. The same would have been true by now for the airlines also were it not for their indulgent governments. As aviation's Byzantine regulations get relaxed and subsidies are reduced, the alliances could come closer to actual mergers.

The Air France-KLM merger is a case in point.