The Globe and Mail

  Vive l'Air France?


Friday, October 24, 2003

When we purchased air carrier KLM Royal Dutch Airlines for the portfolio a little over a year ago, our decision was the culmination of a lot of sifting and analysis of information. The airline sector was in such awful shape at the time, which made it clear to us that a sterling opportunity existed, but it was tough to identify which player had a combination of sound fundamentals and the best future prospects. Our winnowing concluded with the purchase of this Netherlands-based operation at US$9.36 a share.

After a frenzy of negotiations, Air France and KLM have inked a merger that sees the French suitor offering a package it values at 16.74 euros — roughly a 40 percent premium to the Dutch airline's closing price on September 29.

It's a non-cash transaction: Air France is offering 11 shares and 10 warrants for every 10 shares of KLM. Three warrants will allow shareholders to grab two Air France shares at an exercise price of 20 euros, three and half years after the transaction closes next April.

Because the value to the KLM shareholder is entirely contingent on the price of Air France's shares, it means we have to begin our analysis anew. Like most airlines, Air France has been gushing red ink, but despite the combined wallops delivered by SARS, the war in Iraq, high prices for jet fuel, and an air traffic controllers' strike, it managed to eke out a profit of 4 million euros last quarter. The current share price of 13.54 euros is well under the firm's book value of 18.23. The debt/equity ratio is 0.72.

The value of the warrants, which effectively give investors some juicy leverage in a best-case scenario, are virtually impossible to gauge today. Air France values them at 1.68 euros, using the "Black & Scholes" model of option pricing. For coming up with that formula, Robert Merton and Myron Scholes won the 1997 Nobel prize for economics (Fischer Black died in 1995). But although the model has proved effective in pricing short-term options, its accuracy plummets for longer-term contracts.

An exhaustive study this year by Sibson Consulting looked into employee options at 1445 companies over six historical periods, and found that the Black & Scholes prediction was fairly close only about 2 to 5 percent of the time. In fact, it was usually way off, and frequently wasn't even in the ballpark. Apparently, a monkey throwing darts would do as good a job.

As for the probability that Air France will be trading in the low 20-euro range in late 2007 as the formula suggests, that is possible, but unlikely. Either the merger will flop and the warrants will make nothing better than cool bar coasters, or the newly composed airline will take off towards Air France's historical highs in the 75-euro range, where it cruised regularly from 1989 to 1993. In which case, forget the coasters and break out the champagne flutes!!

But which of these diverse scenarios will occur? Ay, there's the rub. Even a Nobel laureate isn't going to help us with that one. Some tea leaves, perhaps?