Air France-KLM Profit Warning

This case study is based on concept of market efficiency in relation to the profit warning of Air France-KLM, a merged leading European Airlines in February 2011

Executive Summary
This case study traces the recent profit warning of Air France-KLM and the stock market reactions with respect to market efficiency, In section two, fundamental analysis is performed based on key performance indicators to assess the strength of airlines in the market. Section three discusses about importance of stock market to its participants and researchers. In section four market efficiency and profit warning studies are analysed in the recent relevant studies. Finally, three relevant market efficiency theories are proposed and tested in the context of Air France-KLM: Does the share price follow the random walk theory? Does the share price respond to events quickly after the announcement? Does the share price of Air France-KLM support the theory of overreaction?

Overall, based on the facts, figures and the market efficiency tests, share price immediately responded to the profit warning news therefore tend to support semi strong market.

 Air France-KLM Profit Warning

Air France-KLM Profit Warning

This case study is based on the concept of the market efficiency in relation to the profit warning of Air France-KLM, a merged leading European Airlines in February 2011.

Europe and a global leader in cargo transportation. The changes to capital structures during the nine month period ended to 31 December 2010 are debt reduced from 6.22 euro billion to 6.06 euro billion whilst equity sharply increased from 5.42 euro billion to euro 7.03 billion. In addition it operates 641 aircrafts which serves 244 destinations in 105 countries with the presence in all continents. See

Introduction
Air France- KLM, leading European airlines issued a profit warning that it would not meet annual operating target of 300m Euros. Chief executive officer pointed out this was due to increased capacity because of adverse weather conditions, traffic control strikes which caused 6900 flight cancellation during the third quarter and increase in oil prices. As a result stock market pushed the share price downwards by 8%. Most of the above problem indicators are common to airline industry proved by IATAs prediction of lower outlook of airline industry due to rising oil price this year. Air France- KLM is a merger of Socit Air France S.A. (Air France) and Koninklijke Luchtvaart

Appendix This case study analyse effects of the warning on the share prices with respect to the market efficiency. The underpin concept of market efficiency is efficient market hypothesis (EMH), it states that any new information to the market is quickly reflected in share price in an unbiased way. The concept of EMH was developed by Eugene Fama in his thesis five decades ago. Different information affects stock prices in different degree such as weak form, semi strong form and strong form. Weak form market efficiency states share price depends on past share price information. Semi strong market relies on past information as well as the publicly available information and strong form utilises publicly and privately held information.

Maatschappij N.V. (KLM) in 2004. The revenue generating activities are passenger transportation (80% of revenue), cargo transportation (12% ) and aircraft maintenance and overhaul services (5%), they secured a leading position for passenger transport in
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competitive forces since 2007 and it has started to incurring loss from 2009/10.

Financial Performance Indicators

This section relate to the semi strong form as accounting information become source of the publicly available information for stock market investors. Using the following key performance indicators (fundamental analysis) would not help investors to spot undervalued stocks in order to earn superior return in an efficient market. The main performance indicators are drawn from profitability, activity and investor ratios. Diagram 1
Net asset turnover (times)

Diagram 2

Asset Utilisation for Air FranceKLM over the last 4 years

Year

ROCE over the last 4 years

This ratio gives a guide to productive efficiency, companys asset utilization at peak in 2009 while it incurred a loss in the corresponding period. This

ROCE (%)

suggest, although assets have been used efficiently to generate sales, increased level of direct and indirect cost must have squeezed the margin.

Year

Diagram 1 shows the profitability of Air FranceKLM by comparing funds invested with profit. It also illustrates airlines profitability is deteriorating during the past four years. This means it faced strong
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with other airlines. The problem highlighted here is the access to information Diagram 3

Why Is Market Efficiency Important?

EPS for Air France-KLM over the last 4 years
Earnings/(loss) per share (in EUR)

Powerful theory Academics and researchers believe that EMH is the widely popular hypothesis in economics and finance literature that have very strong empirical evidence. However evidence also suggests several anomalies exist in the market which eventually questions the

Year

efficiency of the market so that stock prices may not reflect true value in the market.

Diagram 3 follows the pattern of ROCE, a declining pattern which turned to loss in 2009 and further loss in 2010. This is one of most important ratio which determined the price earning ratio and send signals to investors airlines ability to earn future earnings prospects. In considering the above financial performance indicators it is important to note they are based on historical information, backward looking and subject to manipulation by managers. thus in addition to above it would be advisable to incorporate non financial performance indicators to gain a true big picture of the performance. e.g. seat occupancy rate, no of delayed flights, comparisons of performance

Motivate Airlines and investors Primary objective of Air France-KLM must be maximisation of shareholder value. Share price move as a result of new information to the market, it is important because changes in share price affect the value of the company. Accurate share price is extremely important for management in pursuing growth strategies in the value creation process. Similarly investors value of investment affected by fluctuation in share prices therefore presence of efficient market ensures fair reflection of value therefore encourage investors. Because, all relevant information is already reflected in share prices, this encourages an investor to make a positive-NPV
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transaction when buying or selling shares on the market.

true fashion and he was the first to classify the market efficiency into three types.

Optimum resource allocation Rational investors seek returns within the acceptable risk level. Different attitudes to risk enable investors to choose different combination of risk- return portfolios but this decision is based on the fair reflection of share price to arrive at actual cost of investment investors prepared to invest in. poor resource allocation happens when anomalies distort and artificially inflate share price causing investors to fall into the trap. Lower transaction cost Moreover, efficient market assumes no or less transaction cost for investors. Higher transaction cost prevents investors who trade in marginal. Fama (1998) reviewed existing event studies of semi strong form efficient that focused on the overreaction AF-KLM profit warning caused stocks to dip by 8% following the announcement. There are two types of warnings quantitative warnings which include a revised forecast but in this case qualitative warning is issued that the annual operating target would not be met. Despite the negative response by market one might wonder why airlines chose to issue warnings. Skinner (1994) illustrated firms wanted to avoid any legal cost associated with delayed warnings. However manager may not want to give profit warnings because of markets overreaction to the news Kasznik and Lev (1995). Profit warning event study

Alternatively investors may invest in index funds.

Recent Relevant Studies

Classical study The concept of EMH was discovered by Fama in 1965, in an efficient market stock prices will appropriately reflect the effects of the information in a
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and under reaction theories of market efficiency. This reaction theory was originally developed by Da

Bondt and Thaler (1987) investors reacts differently depending on the type of news they receive, this will result in abnormal returns. Some study say market predicts based on the industry and economic circumstances of airlines (rising oil price) therefore

 Air France-KLM Profit Warning

profit warning by Air France- KLM would not be a big surprise to market. Further analysis also suggests that adverse impact for large organisation is mostly felt earlier than small firms they react after announcements. Both studies are in favour of Air France-KLM.

EMH has been accused for reason behind the worldwide economic recession during 2007-2010 in particular they argued over confidence of the EMH made them unrealized the bubble breaking. But supporters defended that theory was sound but failure attributed to human errors and biases.

Adaptive market efficiency Apart from the above event studies of EMH, another growing area of concern is the alternative theory to the EMH. Malkiel et al. (2005) stated there appeared to be contradiction between two schools of thoughts of EMH and the behavioural finance. Recent survey by Yen and Lee (2008) is consistent with the above view it demonstrates EMH is increasingly targeted by behavioural finance academics more than ever before. For instance the impacts of cognitive biases make investors to buy overpriced stocks. In response to the above issue an alternative theory of Adaptive market efficiency is proposed. It accommodates both EMH and behavioural finance perspectives such that EMH changes continuously according to different time periods and in different markets. This is again proved by Sugiyama (2009) he presented evidence that USA stock market efficiency varied during the past five decades

Testing Market Efficiency Theory

Share price of Air France KLM have been tested using theories of market efficiency. They are: share prices follow random walk; share prices respond to events in particular profit warning and share prices overreact to the event.

Theory 1, Random Walk Theory

The empirical evidence of weak form test showed share price follows a random walk. Random walk theory was identified by Louis Bachelier in his thesis of the theory of speculation century ago but it became popular upon discovery of Maurice Kendall. this theory says there is no predictable pattern for share price movement it can either go up or down independently. Diagram 1

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Share Price Movement of Air FranceKLM over a year

Share Price

return (AR=R-Rm), market return in turn measured using S&P index.

Date

Diagram 1 illustrates random walk pattern of share price over the last one year. The correlation of 0.35 is a negligible value and indicates there is no correlation between share price changes of previous day to the next day. Theory test prove share price has no predictable pattern thus consistent with random walk
Share price

Diagram 2

Share Price Movements of Air France-KLM

theory. Therefore historical stock price information is little useful for future prediction.

Theory 2, Share Price Quickly Adjust

Share price rapidly adjusted following the public announcement of profit warning by airlines. This is consistent with the semi strong efficient market. As mentioned earlier, in an efficient market Diagram 2 graphically represents two days before and after announcement of Air France- KLM. The announcement was made on 9th of February share price quickly adjusted and went down dramatically on the 10th February and the following day it fell down at a slower rate. The rate at which information processed by market would suggest market is semi strong and
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Date

fundamentalist cannot beat the market consistently. Event studies are used to test semi strong form market. It gives an overview of speed of share price adjustments to the new information. Abnormal returns are calculated deducting market return from the actual

 Air France-KLM Profit Warning

investors processed the profit warning information rapidly as a result share price have fallen.

Diagram 3 indicates share price fluctuation during the post warning period. Graph shows a rapid fall in share price following the announcement and then it starts to

Theory 3, Overreaction Theory

EMH suggests different investors respond to

go back to the mean values. This suggests despite the failure to meet profit targets airlines enjoys a stable performance track record evidenced by leading position in Europe.

information in different degrees such that one can overreact or under react to the announcement of the given company. As a consequence, share price respond to random thus no investor can make superior returns consistently in an efficient market. Given that earnings are random walk, if investors believes bad news to earnings are mean reverting then they think it is a temporary event thus share price under react to the news. On the other hand if investors think profit warning is an indication of future revenue fall and this expected to continue they react by selling shares rapidly. See appendix Diagram 3
Share Price Movement for Air France-KLM

Discussion & Conclusion

Marker efficiency theory testing was performed using share prices of Air France- KLM. The result suggests share prices movement is consistent with random walk theory. Diagram shows share price vary between 8-15 euros over the last year. Volatility of earnings is the consequence of bad weather, strikes and rising oil price. As per performance indicators asset utilization is at maximum despite the falling profits this would

Share Price

suggest this may be a temporary situation given its long established successful history. The timely and rate of share price adjustments to announcement would suggest market is semi strong. There are two reasons as to why share prices
Date

fluctuate; first is the announcement of profit warning and next is the subsequent trading activities of the investors. As a result share price fell initially and will
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revert back to equilibrium. Airline industry was hit by many threats on top of the economic recession , IATA lowered the airlines profile recently this year. This may suggests this trend will continue for a this year and therefore any new investment require careful consideration. Application of overreaction theory revealed there is no significant overreaction it only happened in short period after announcement. Investors reacted by predicting further fall in revenue. Any abnormal returns caused by market inefficiency will eventually disappear. Long term abnormal return studies would empirically prove.

Xu, W. (2008) Market reactions to warnings of negative earnings surprises: further evidence. Journal of Business Finance & Accounting, Vol. 35 (7-8), pp. 818836. Available at: http://0web.ebscohost.com.brum.beds.ac.uk/ehost/pdfviewer/ pdfviewer?sid=c7aee905-09db-4aa4-96d7afa63fe5d071%40sessionmgr13&vid=4&hid=7 [Accessed 7 April 2011].

Appendices
Aviation Industry

References & Recommended Further Reading

Airline industry deregulation began in late 1970s in USA and thereafter in European countries. The European airline industry is highly fragmented and

Bulkley, G. Herrerias, R. (2004) Stock returns following profit warnings. University of Exeter working paper no. 04/02. Available at: http://administracion.itam.mx/workingpapers/bulkley herrerias.pdf [Accessed 7 April 2011]. Lim, K-P. Brooks, R. (2011) The evolution of stock market efficiency over time: a survey of the empirical literature. Journal of Economic Surveys, Vol. 25 (1), pp. 69-108. Available at: http://onlinelibrary.wiley.com/doi/10.1111/j.14676419.2009.00611.x/pdf [Accessed 7 April 2011].
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many airlines strive to form alliances with each other in an attempt to restore profitability and maximising shareholder wealth. The major competitive threat to airlines comes from not only other airlines but also speed train links to cities. In response aviation industry introduced low cost carrier which allow direct internet booking, no meals on flights, use of secondary airports to cut down landing and takeoff fee. Another important feature of aviation industry is aircrafts are mostly financed by debts and this impact

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the gearing ratios . to address this issue and to utilize the capacity and to have presence in the unfamiliar market airlines formed strategic alliances with each other. Furthermore increased oil prices and middle east crisis severely affected the airline industry this year. Air France-KLM also faced with exchange rate as the oil price in barrels is denominated in US$.
Market efficiency tests

reversion. This theory says even if the anomalies cause fluctuation and profitable opportunities arises due to inefficiencies in the market, stock prices eventually go back to the mean values. However, Weihong Xu presented evidence that negative reaction by investors is more associated with expected future fall in income rather than the investors over reaction. AF-KLM issued warning on Wednesday which must have had larger impact on stock price than if they did on Friday. Because warnings on Friday evening take advantage of weekend effect consequently on Monday impact on share price would have been low. Despite stock market respond negatively to any negative news management of Air France made a profit warning in

Weak form market is tested using correlations tests, run tests, filter tests and cyclical tests; semi strong form market is tested with event study methodologies and strong form efficiency is tested by examining the returns of insiders, or testing the changes in volume or returns prior to profit warning. Market anomalies timing effects, size effects, growth/value stocks and bubbles deteriorate the efficiency of market thus make share price failed to reflect true values. This will exist only for short period, as in the long term markets are efficient. Theory 3: overreaction Behavioural finance suggests over reaction and under reaction theory emerged as a result of cognitive biases of processing information by investors. Market overreacts to the profit warnings by pushing stock prices downwards. Most investors are speculative and they buy and sell hottest stocks causing marker inefficiency EMH response is the theory of mean

February. The motivation is to reduce information asymmetry between management and stock market to have good relationship with investors and analyst in the long term. Research suggests share price fall after bad news stock market never penalise warning firms

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