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British Airways Hit by Heathrow Fiasco

With its new terminal marred by logistical snafus, BA faces harm to image and bottom line—just as costs and competition are set to soar

It took five years and $8.6 billion to build, but the disastrous opening of the new Terminal 5 at London's Heathrow airport has managed to seriously damage the image of British Airways (BAY.L) in less than a week. "BA's reputation is more tarnished from this problem than from any other in the last three years," says Howard Wheeldon, senior strategist at brokerage BCG Partners. It has caused "collateral damage to customer confidence."

For BA and its chief executive officer, Willie Walsh, Terminal 5 was meant to be a fresh start (, 3/27/08). It was a chance to ease congestion at Heathrow, improve the flying experience for passengers, and over time even reform outdated working practices (, 3/4/08). At the terminal's lavish Mar. 17 unveiling, attended by Queen Elizabeth II and various government officials, BA Chairman Martin Broughton predicted the new terminal would "put some fun back into flying."

Try telling that now to BA's customers. Since Terminal 5 went into service on Mar. 27, BA has had to cancel 381 flights (through Apr. 3) and is sorting through a backlog of 20,000 undelivered bags (, 3/31/08). Problems have ranged from computer glitches with the baggage handling system to insufficient security and staff parking. Citibank (C) analysts estimate the fiasco could cost BA as much as $50 million, while British brokerage firm Collins Stewart (CLST.L) figures the financial damage could be twice that.

No One's Blaming the Chief

For Walsh, who had publicly counted down the days until Terminal 5's opening ever since joining BA in October, 2005, it was a major humiliation. "I take responsibility for what happened," said the 46-year-old CEO in a Mar. 28 statement. "The buck stops with me."

No one, with the exception of disgruntled passengers, is calling to remove Walsh from the cockpit—yet. Indeed, his stewardship to date of the world's No. 4 international airline gets good reviews. Walsh has cut costs, reformed outdated labor practices, and still managed to keep the unions cooperative, says transport analyst Gert Zonneveld of brokerage Panmure Gordon (PMR.L).

Zonneveld reckons that for the year ended Mar. 31, 2008, BA's operating profits soared 48%, to $1.6 billion, on revenues up 3%, to $17.3 billion. Even after the financial impact of the Terminal 5 fiasco, BA is likely to come close to hitting its target of 10% operating margins. That compares favorably with 6% operating margins at Air France-KLM (AIRF.PA) and just 4.2% for American Airlines parent AMR (AMR).

Open Skies, More Trouble

But rebuilding BA's reputation won't be easy. The airline is having to contend with the fallout from the Terminal 5 debacle at the same time it is seeing its home market opened up to competition via the new North Atlantic Open Skies agreement. The treaty to liberalize air travel, which went into effect Mar. 31 (, 2/28/08), allows operators from either side of the Atlantic to fly anywhere within the EU and the U.S. (, 1/14/08)

The battle will be fiercest at Heathrow, the world's busiest international airport. That means an already embattled BA, which controls more than 40% of the takeoff and landing slots at Heathrow, will face stiff competition for lucrative transatlantic passengers as rivals such as Continental (CAL), Delta (DAL) and Northwest (NWA) add capacity. According to the International Air Transport Assn. some 7,000 additional seats per week may be added between London and New York as a result of the treaty.

Analysts at BNP Paribas (BNPP.PA) estimate the addition of new carriers to Heathrow also will increase the number of business class seats by 14%. As a result, BNP figures Open Skies could slash BA's profit margins in the fiscal year ending Mar. 31, 2009 to just 4%, down from the 7% the airline has been predicting, representing a $540 million drop in profits.

Consolidation of Rivals Threatens

That's just one of many challenges BA faces. As with other airlines, its costs are rising as oil soars above $100 a barrel. For the year ending Mar. 31, 2009, BA's fuel bill is expected to hit $5 billion, roughly 30% of its entire cost base, says Panmure Gordon's Zonneveld. And passenger demand is likely to fall in the face of the global economic slowdown and weak dollar.

At the same time, rivals such as Air France and Lufthansa (LHAG.DE) have led a wave of airline consolidation in Europe, while BA has so far remained on the sidelines. Air France kicked off the process with its 2004 takeover of Dutch carrier KLM, and now is bidding to take control of Italy's Alitalia (AZPIA.MI) pending union and shareholder approval (, 12/11/07). Germany's Lufthansa acquired Swiss International Air Lines and might take over BMI British Midland, of which it already owns 30%.

In contrast, BA's two previous attempts to buy American Airlines were struck down by competition authorities. BA also has long eyed Spanish carrier Iberia (IBL.F), the leading carrier linking Europe and Latin America, but has moved cautiously on a takeover (, 11/27/07), Yet on Mar. 19 BA raised its Iberia stake to more than 13%, and Walsh says he will consider increasing the stake further. Analysts applaud the move. "BA has been the blushing bride many times, but the airline can't just sit there as a solely British carrier," says Peter Morris, chief economist with consultancy Ascend Aviation. "Iberia is the last game in town."

Risk of Pilot Strike

Then there's the growing risk of a pilot strike at BA, potentially the first in nearly three decades. The pilots are outraged over BA's plans to outsource pilot jobs for a new subsidiary it's launching, called OpenSkies, that will provide direct service between Continental Europe and the U.S. "BA's decision to outsource caused enormous anger," says a spokesperson for the British Airline Pilots Assn. (BALPA), whose members include 3,000 of BA's 3,200 pilots. "Morale is low."

It's not just the pilots who are struggling to stay motivated, either. BA's biggest union, GMB, which represents workers—from check-in staff to engineers—says that since the botched opening of Terminal 5, morale among its 4,500 BA members is at "rock bottom," according to Gary Pearce, regional officer for GMB in London.

In a Defensive Position

If Walsh is to rebuild BA's reputation with customers, analysts say, he'll need to start by motivating his own staff. After all, the airline business is a service industry. BA needs to do more than simply offer cut-price deals or run lavish ad campaigns, which is how the company often has maneuvered itself out of previous jams.

To recover from a setback of this scale, BA also will need dramatically to improve its record for service and reliability, which has slipped in recent years. "BA is in a defending position as increased competition comes to Heathrow," Wheeldon says. "They will have to go beyond price and compete on service and you can't deliver that service without motivated staff."

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