Sep 2008

So, British Airways has finally taken the plunge. It and Iberia announced their engagement: a new company, to be listed on the London and Madrid stock exchanges, will be formed to acquire the whole share capital of each existing airline in a full share swap. Each of the current companies it is envisaged will retain their separate brands and identities while, with regulatory approval, the two operations will be able to coordinate schedules and fares across their whole networks. The two companies expect that the prenuptial negotiations will take several months. The agreement appears unanimously backed by the respective company boards of directors.

BA has come close to the altar on many occasions, notably shying away from KLM in the 1990s and Swiss in the '00s — and other deals have faltered even before they became public. It also had its fingers badly burnt in attempts to spread its wings into non–UK European markets — specifically dba and Air Littoral. Meanwhile, Iberia has intimated for some time that it did not envisage an independent future. Last year comments such as these led to an approach by TPG — joined by BA with its 10% stake — only to be rebuffed very successfully by one of Iberia’s other core shareholders. Since then much has changed: Spanish elections over; fuel prices doubling; credit crunch; weakening economies.

The two companies have been closely linked for a decade. BA acquired its core 10% holding and two seats on the board as part of the privatisation process of IB eight years ago. Iberia is a core member of the oneworld alliance. BA and IB have operated a successful joint venture on UK–Spain routes and created a plethora of code shares. As joint members of oneworld their FFPs are fully linked.

But it may be a surprise that BA — which after all tends to suffer a perception of corporate arrogance — is willing to present this deal as a merger of equals rather than a takeover. However, life has changed for BA too. While it has concentrated on getting its finances in order after the damages of September 11, SARS, and its UK pension crisis, it has seen arch–rivals Air France make a success of stealing KLM while being able to expand healthily into lower costs at the four–runway Roissy–CDG and Lufthansa expand profitably both organically (with the help of capacity at its successful secondary hub in Munich) and through its subsequent acquisition of Swiss. At the same time it has suffered extreme constraints at its Heathrow base and has shed destinations and routes, while — unlike its main competitors — being denied anti–trust immunity on the Atlantic. It has been at a significant operational disadvantage albeit somewhat mitigated by the protection provided by fortress Heathrow. However now, with the introduction of transatlantic open skies, it is faced with increasing pressure on its core routes: and London is by far the most attractive destination in Europe — not merely the European gateway on the Atlantic, but also by far the largest point–to–point O&D traffic of any airport system in Europe and therefore having the highest density of premium yielding routes.

What appears to have changed BA management’s views is a realisation that it had underestimated the revenue enhancing benefits of a European merger — effectively intimated by a comment by the company’s CEO Willie Walsh earlier this year. This suggests that in the past they may only really have looked at cost savings to evaluate potential deals — and is in effect a backhanded compliment to Air France’s Spinetta and Lufthansa’s Mayrhuber. To understand this it is worth looking at the respective experience of Air France–KLM and Lufthansa–Swiss.

Removing competition

Air France opportunistically acquired KLM in 2004. This was the first true major cross–border airline acquisition in the EU deregulated era — and the first among flag carriers since the formation of SAS in 1956. At the time the two companies were suffering from the effects of the aftermath of the September 11 attacks on the United States, the SARS epidemic and the Second Gulf War. KLM in addition had been particularly damaged following its withdrawal from its alliance with Alitalia (what irony!) — and strategically appeared to be floundering. The net effect of the AF/KL "merger" was to remove competition — surely one of the prime reasons behind consolidation. The regulatory penalty was minor: to allow entrants on the Paris–Amsterdam route (which really has nothing to do with the competitive changes inherent in the deal). Whereas Air France had the advantages of a good hub at Roissy–CDG, Paris being the only destination in Europe after London with a reasonably strong point–to–point market — it had over the years been competing directly with KLM. The combined group was now effectively able to coordinate schedules and fares, cut head–to–head flying, expand attractive frequencies through judicious flight timing, and redirect weak routes through only one hub and network. As a result the AF/KL group created very strong revenue synergies from directing traffic through its now double–hub system. As these revenues are incremental (possibly initially accounting for only 1.5% of group revenues), the underlying costs are minimal, and the net impact on the group’s total profitability have probably lain in excess of 15% of total operating profits.

At the time of the merger there was much cynicism of the ability to generate returns — but the incremental revenues from the double–hub operations appear to have been far in excess of the group’s own expectations. At the same time the group’s presentations suggest strong cost synergies — but many of these cost savings have come from cost reduction programmes introduced by the respective carriers and put in place before the merger. It is only now that the group has started to look at joint cost savings; and has now implemented a new joint management structure to help ensure that the two continue to minimise costs to continue to create shareholder value — and the group’s presentations show that they are on track to achieve €1bn in combined synergistic benefits by 2011.

The Lufthansa acquisition of Swiss has a slightly different history. Swiss (the rump of the failed Swissair) had a dire legacy. It too (like KLM) in its previous incarnation had built a route network designed around a hub transfer operation at Zurich unsupportable by local traffic. In an ill–advised attempt to gain mass, it had built minority stakes in other airlines for cash only to be hit by a severe cash crisis following the September 11 attacks on the US. Lufthansa only agreed to acquire the company on the condition that it had put its own house in order and effected its own restructuring plan — and on condition that the Swiss government renegotiated all the bilateral air service agreements to allow non–Swiss ownership of the company operating under Swiss nomination. Like Air France, Lufthansa has kept the independent brand and has avoided the age old industry mistake of trying to merge operations and personnel. Unlike Air France, however, Lufthansa was able to slot SWISS into its existing matrix of a portfolio of airline brands and types under the group ownership umbrella. It too has apparently generated significant revenue and cost synergies — although according to its presentations not yet as important to total group profitability as achieved by its French rivals. Neither Lufthansa nor Swiss have good natural point–to–point O&D markets at their respective base cities — but they do have very efficient hubs at those airports. Lufthansa is heavily constrained at its home base at Frankfurt (at least until the fourth runway is built in ?2011) but Swiss has a long way to go. In this perhaps, Lufthansa and SWISS have a greater opportunity than the AF/KL operation to generate more multi–hub route markets.

Expectations

Both the AF/KL and the LH/LX deals have a key advantage — and this may be the only reason that they have been able to generate such apparent returns. Their respective hubs are all within the area of the greatest density of population in Europe — the "blue banana" that stretches in a graceful curve from London along the Rhine through Switzerland to Milan, within which lies half of the European population. In one sense this means that the respective hub airports can claim superior catchment areas in themselves — although this does not always transfer into actual traffic. Importantly the hubs are respectively close together. As a result the opportunity to market to a passenger who has to transfer at some hub or other, will — so long as the schedules are timed to permit it — generate flight timings at the top of the first screen of any flight request enquiry.BA/IB may expect to gain the same sort of revenue and cost benefits. However, in total contrast to the other two examples, London and Madrid are on two extremes of geographical Europe, possibly limiting the potential for multi–hub flight routings. In addition the two companies have been in the same global alliance for the past decade and as a result their FFPs have been fully linked, leaving less room for incremental benefits. However, it is fair to say that there is much less of an overlap than there was for either AF/KL or LH/LX and the two carriers do not really compete head on for transfer traffic. BA’s strengths are primarily on the North Atlantic and to former British imperial destinations — but it also benefits from London’s pre–eminent position. One could not yet describe Heathrow as an efficient hub, even though BA should now be able to start to restore its competitive positioning against Paris Amsterdam and Frankfurt as Terminal 5 is now operating smoothly.

Iberia’s niche strength is on routes on the South Atlantic — reflecting the very strong cultural links with Latin America — while it has also been efficiently building capacity into Africa, and has no operations to the Middle or Far East. Furthermore, (notwithstanding the current problems surrounding the cost of fuel) both are in reasonable financial health. Iberia in particular has been very successfully restructuring its operations — helped to a great extent by the new runways and terminal at Barajas. It has significantly cut back on domestic operations that do not touch Madrid (some being passed on to affiliate Clickair) while emphasising its hub wave system at Barajas and at the same time expanding strongly on the Latin American routes.

Nevertheless, revenue and cost saving initiatives will no doubt be made — and the two companies are obviously discussing the integration plan in detail before they launch the merger. Strategically it does at least put the group at a similar size to the other two major European legacy carriers and provides further consolidation in the European industry. Of far more importance, financially and strategically, will be the outcome of the attempts to gain anti–trust immunity on the north Atlantic and the potential through establishing a joint venture with American to recover further from competitive disadvantages.