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THE SKY’S LIMITS

Fragmented and unprofitable, the airline industry has rightly been ravaged by the recession, so why is the much-needed consolidation and liberalisation of aviation seemingly still so difficult to achieve? asks Lucy Fitzgeorge-Parker

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When United Airlines began merger talks with US Airways in April, Continental Airlines’ CEO, Jeff Smisek, phoned his opposite number at United and blocked the match, later explaining: “I didn’t want him to marry the ugly girl. I wanted him to marry the pretty one.”

Perhaps surprisingly for investors, for whom airlines have often been something of a coyote date, there has been a recent spate of marriages in the aviation sector. The United-Continental tie-up follows the stateside merger of Northwest and Delta; in Europe, Lufthansa has acquired a squadron of smaller carriers in the past five years – scooping up Swiss, Bmi, Austrian Airlines and Brussels Airlines; and in 2008, four years after their merger, Air France and KLM bought regional carrier VLM Airlines. Currently, BA and Iberia are on the verge of tying the knot.

It is tempting to see these high-profile unions as evidence of a welcome trend towards consolidation in a notoriously fragmented and unprofitable sector. But appearances are deceptive – the barriers to M&A in aviation are, in many ways, as high as ever. Even at a national level, carriers wanting to get spliced have to appease local labour unions and antitrust watchdogs, and any type of cross-border deal has to get past governments jealously guarding their own airlines with all the political and regulatory means at their disposal. At their simplest, these take the form of caps or outright bans on foreign ownership of airline equity. This hit the headlines in March, when the EU accused the US of reneging on commitments to raise the cap on European ownership of American Airlines from 25% to 40% in the second stage of 2007’s Open Skies deal. US officials insist that the original agreement represented a statement of intent, not a guarantee, but the main point to emerge from the dispute is that the Obama administration has no intention of picking a fight with the powerful airline workforce unions in order to get the necessary legislation through Congress.

In addition to the risk of provoking labour unrest, politicians also fret about security issues and, in the case of smaller countries, loss of connectivity following external takeovers. Then there is the nebulous issue of national pride, which has prompted governments to block deals even in countries with no formal caps on foreign ownership. Talks of a merger between BA and Qantas in 2008 quickly foundered in the face of popular outrage in Australia, while even in the depths of the recent recession governments chose to prop up ailing carriers such as Japan Airlines (JAL) and Alitalia rather than relinquish control to foreign suitors.

And limits on ownership aren’t the only barrier to cross-border M&As. Almost more daunting to predatory airlines is the prospect of negotiating the Byzantine maze of bilateral aviation treaties that control flying rights across the globe, a legacy of botched post-war legislation that failed to establish a multilateral agreement on international air traffic. Despite a flurry of open skies deals in the past decade – the US alone has signed nearly 100 in recent years – there are still around 4,000 of these bilateral treaties in force, limiting flying rights to carriers attached to the signatory countries.

Expansionist airlines have found ways round these restrictions – Lufthansa, for example, parked its shares in Swiss in a local holding company while negotiating flying rights with all the non-EU countries involved, and Air France and BA have used similar models – but the process can still take up to two years. The growth markets of China and Russia are reportedly the most difficult to crack, with the latter in particular having acquired a reputation for both obstruction and caprice, as exemplified by the Moscow government’s recent threat to void Austrian Airlines’ flying rights in the event of a full Lufthansa takeover. Other developing countries, including India and Ukraine, have made their cooperation conditional on airlines entering into codeshares and other tie-ups with their national carriers.

In the face of all these obstacles, the fact that any cross-border deals are getting done at all would seem to suggest that there is a compelling case for consolidation in the airline sector. That is certainly the position of trade body IATA (International Air Transport Association), which has been tirelessly campaigning for global liberalisation for decades, most recently launching its Agenda for Freedom in 2008. It argues, indeed, that the removal of barriers to M&A is essential if the aviation sector is ever to shake off the curse of cyclicality and become consistently profitable.

“The airline industry hasn’t been healthy for some time,” says Steve Lott, IATA’s head of communications, North America. “On average it lost $5bn a year in the last decade, so we need all the help we can get in terms of changing the business model and allowing airlines to restructure. These government restrictions are a major barrier in preventing airlines from trying to recover.”

Lott points out that the airline sector is still extraordinarily fragmented compared to telecoms and banking, with even the largest carriers only accounting for around a 2% market share. “There’s no reason that airlines are a unique industry,” he adds. “If we remove all these barriers it would go a long way towards giving airlines access to foreign capital and investment, and allow them to work with a foreign carrier to develop a global network that can maximise profit.”

Douglas McNeill, aviation analyst at Charles Stanley Securities, agrees: “There are too many airlines and that’s why they compete away on all these margins and collectively make a poor return on capital. If governments were willing to stand back and let a commercial solution develop when their own airlines got into trouble, then you’d see an almighty M&A boom.”

Yet even advocates of liberalisation admit that it would not be a silver bullet for the industry. The rewards of consolidation are frequently uncertain and the time it takes to unlock them substantial. The BA-Iberia deal is expected to present cost-cutting benefits of no more than 2%–3% in margin terms – partly due to heavily unionised workforces – and even that is unlikely to be achieved within five years.

“Consolidation is not a panacea for the problems of the industry,” says veteran aviation analyst Chris Tarry. “Even a three-year plan in the airline industry is going to be out of date pretty quickly.”

Others are equally sceptical. Philip Baggaley, managing director of corporate and government ratings at Standard & Poor’s in New York, says there are plenty of reasons other than industry fragmentation that explain airlines’ failure to make a good return on investment. “They’re very cyclical; they’re subject to fuel price fluctuations; they’re subject to wars, terrorism, epidemic diseases and volcanic eruptions; and they’re labour intensive, in that the pay of unionised employees is often a large part of the cost structure, and capital intensive, in that the planes are very expensive.”

The curse of cyclicality is also enhanced by the availability of credit – when times are good, banks and leasing companies are happy to lend money against airliners, which are seen as liquid, mobile and tangible assets, making it relatively easy for new competitors to enter the market. “We saw a lot of those five or six years ago and we’ll see more as soon as the economic cycle picks up,” says McNeill. “There are always people who want to chance their arm in the airline business. To put the industry on a consistently profitable basis you’d have to have a more disciplined approach on the part of industry financiers.”

And then there are the no-frills carriers – nimble, flexible and unencumbered by unionised workforces. “In a situation where there is quite a bit of consolidation and the airlines were able to raise ticket fares, a further price advantage would open up for low-cost carriers, who would probably expand to fill the space and continue to offer very tough price competition,” says Baggaley.

Under the circumstances, many carriers have, unsurprisingly, chosen to pursue alternatives that offer the benefits of M&A without the need for equity investment. The big global alliances – Star Alliance, OneWorld and SkyTeam – have been expanding steadily into new markets, while individual airlines have opted for closer cooperation involving revenue-and profit-sharing. Air France and Delta have successfully paired up on the transatlantic route, and BA and American are negotiating antitrust immunity for a similar joint venture, while American and United are hoping to team up with, respectively, JAL and ANA of Japan on their Pacific routes.

This is not to say, of course, that the golden age of airline mergers is already over. At a local level, the vast majority of Russia’s 168 carriers are unlikely to remain independent for long – indeed, Aeroflot has already begun the process of reabsorbing the babyflots that were spun off after the fall of the Soviet Union – and further consolidation is expected within China and Mexico. Struggling European airlines such as Scandinavia’s SAS, Alitalia, Greece’s Olympic Air and Portugal’s TAP are being mooted as takeover targets, and Turkish Airlines recently hinted at an interest in Polish flag-carrier LOT, while US Airways, jilted by United, may yet turn to its former suitor American Airlines.

Yet unless there are some far-reaching changes in the industry, it seems probable that for many airlines the saying “always the bridesmaid, never the bride” will continue to hold sadly true.

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July 2010

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