A vintage year for privatisations March 1999

1999 could be by far the most active year ever for European airline privatisations. Air France, Iberia, Austrian and Alitalia are expected to come to the market with secondary offerings that will further dilute their level of government ownership. In addition, regional and niche players are looking to tap into the equity markets. Do the equity markets have the appetite for this onslaught; why all this activity this year; and what should investors be aware of when looking for good value?

Three of the four flag carriers coming to the market in 1999 — Air France, Alitalia and Iberia — have been through the European Commission’s state aid process. All three airlines have emerged with their balance sheets restored and, equally importantly, their workforce and unions more attuned to some of the harsher realities of commercial life. Embarrassing as it is for a government to have to seek approval from the EC to rescue a high profile public company, there can be major benefits to the exercise.

Restructuring businesses is a painful process, and one that usually requires changes in long–established working practices and often job losses. Governments and the senior managers they appoint to run their airlines often have not had the conviction to carry out reforms themselves. Union conflicts are usually bloody, make bad press and can be potentially vote–losing. Placing the blame at the door of EC bureaucrats is sometimes viewed as an easier option.

The EC state aid approval process for many airlines has carried an obligation for the state to embark on a privatisation process when market conditions permit and when the airline is financially fit enough. Although the EC has no formal powers to insist that a government sell off its airline, the EC does have to give its approval for any funds that a government wishes to put into its airline under the Market Economy Investor Principle (MEIP). The MEIP rules only apply when there are no private investors in the company.

As Iberia, Air France and their respective government shareholders discovered, MEIP is a time–consuming and expensive process. Moreover, the EC has the power to place restrictions and make conditions that will determine the future strategy of the airline, including selling off assets and limiting capital expenditure.

So the governments of France, Italy and Spain, encouraged by the EC, have decided to embark on the partial sale of their airlines to the private sector. Each airline comes with repaired balance sheets and an EC inspired and approved cost reduction programme. Each has returned to profitability, and the equity market specialists at the relevant investment banks have persuaded the governments that there is enough investor appetite for a successful flotation.

Membership of strategic alliances

Having an association with a global alliance is certainly beneficial to flotation prospects and also likely to increase the sale proceeds. Private investors will probably feel comforted that successful carriers such as British Airways and American are taking a 10% stake in Iberia and that they will be bringing commercial skills to their new partners.

Yet the major airlines themselves have a very patchy track record in their own investment history. For example, British Airways, which is probably the most acquisitive airline in the world, has made some questionable investments. Although it eventually emerged from its investment in USAir showing a profit, for many years the shares in the US carrier traded well below the price paid by BA, and the dividends due to BA were at one stage suspended.

Other investments made by British Airways provide examples of why private investors should be cautious in investing alongside alliance partners. From a strict RoI perspective, BA’s investment in the shares of Deutsche BA and TAT have been questionable at best.

Both carriers have been loss–making and therefore unlikely to have provided an adequate return to BA in terms of dividends. While British Airways recognises strategic benefits from owning these carriers, these benefits may not apply to a private shareholder.

Air France: hugely oversubscribed

It is likely that the Air France sale will eventually be the first of possibly two or three tranches sold by the French government. Therefore, it was important that the sale of the first tranche was well received by the investing community so that appetite remains healthy for any subsequent tranches. Also, with the employees expected to take up their allocation of shares that would give them roughly 13% of the airline, an unsuccessful float was never on the cards.

The first phase of Air France’s privatisation took place on February 22nd 1999. Some 17.4% of the airline’s capital was placed on the stock exchange and put an initial valuation of the airline at roughly US$3.5bn.

The process was a success. The international portion was 41 times oversubscribed and the domestic tranche 12 times oversubscribed, which ensured a healthy demand in early trading. The shares closed on their first day of trading at Euro 16.1 — some 13% above the offer price.

The comparative market capitalisations of British Airways, Lufthansa, KLM and Swissair are shown in the table below. The potential exists for Air France to achieve the same level of profitability as its peers, and the advantage of having an unconstrained hub is a key selling point for the French airline.

But there are two questions investors must ask. First, will Air France be able to achieve and maintain a competitive cost base that will allow the airline to compete with rivals British Airways and Lufthansa in good times and bad? And second, will the airline be able to grow at twice the rate of the market in order to recapture lost market share, which is the stated company policy, without destroying yield and lowering profit margins?

Iberia : major BA/AA influence

The first stage — whereby British Airways and American have acquired some 10% of Iberia through a joint venture company — was completed in February 1999. In March, the Spanish government, through the state holding company SEPI, will sell a further 30% of the airline directly to institutional investors.

In a third phase some 50% of the remaining state–owned shares will be ceded to the private sector probably through a public share offering on the Madrid stock exchange later in 1999. Iberia will also become a member of the oneworld alliance before the end of this year.

British Airways and American receive two seats on the Iberia Board and representation on the Board’s delegated committees. Both British Airways and American have pledged to retain their shares in Iberia for a minimum period of three years.

However, their influence extends beyond that: 30% of the votes carried by the institutional shareholders are been pledged to BA and American on certain, but unrevealed, issues.

Alitalia: the appropriate public share

The second phase of the privatisation of Alitalia has now been delayed to probably the second half of 1999 by Italy’s current left–wing government. The Italian government retains a 51% stake in the airline, with private investors holding 29% and the employees 20%.

The timing of the second phase sale now appears to rest on a government decision as to what is the appropriate level of retained ownership in Alitalia. There is a concern that if the government sells, for example, another 20%, the pilots will take up a significant share and gain effective management control at the airline.

Investors will be wooed by the prospect of material benefits arising from Alitalia’s alliance with KLM and Northwest. But there are also some concerns about how much of the alliance benefits will accrue to Alitalia and how much to KLM.

Austrian: bankrolling eastern expansion

Austrian is coming to the market as part of a strategic alliance, bolstered by equity stakes from several airline shareholders. Although the airline is part of Swissair’s Qualiflyer grouping with Swissair holding a 10% stake, Austrian also has two more passive shareholders in Air France and All Nippon, which hold 1.5% and 9% respectively.

The Sch3bn ($240m) share offering, which is expected in spring 1999, (it was originally planned for 1998 but postponed due to the adverse stock market conditions) will see the Austrian government share in the airline diluted to 39%. The funds raised will be used to bankroll Austrian’s expansion of services in Eastern Europe where it ranks second behind Lufthansa in terms of the volume of east–west European traffic handled.

The role of investment banks

The fees earned by investment banks in major flotations are significant, and therefore the competition to win such profitable mandates is fierce. Separate roles are usually available, one group of banks advising the government, and a second set advising the airline. The government advisors have the primary role, conducting the sale process, including setting the price and forming a consortium of banks that will underwrite the issue.

The advisors appointed by the management of airlines will look after the carrier’s interests (which often involves trying to talk down the initial price at which the shares are issued) and may be retained by the airline once the flotation is completed in order to advise on brokerage matters and consequent M&A activity.

The consolidation of the investment banking industry has left a handful of players that have a truly worldwide presence and therefore capable of handling a global share offering. It is likely that any future privatisations will include at least one of these bulge–bracket firms and they are often asked to sit alongside banks that represent the local market.

Thus with the Air France privatisation roles have been given to French banks SG Investment Banking as global lead manager, and Credit Agricole Indosuez and Lazard Capital Markets as global joint lead managers, with the bulge–bracket tier being represented by Morgan Stanley Dean Witter acting as global joint lead manager.

If the sum total of the above were not enough for the investment community to digest in one year then it should be remembered that some privately owned airlines are expected to come to the market, either this year or next.

British Midland has retained Dresdner Kleinwort Benson to examine the possibility of conducting an IPO. EasyJet is also rumoured to be seeking a flotation on both the London stock market and on NASDAQ. The current strength of the European stock markets would suggest that there is probably enough liquidity to ensure that all of these share issues will be completed, but it would be prudent for the investment banks to be cautious about the pricing.