Air Canada Shoots For The Stars

Eat or be eaten: That's the law of the jungle, but it's the law that rules the skies these days, too. And it goes a long way toward explaining the recent moves of Air Canada. Until recently, the Canadian flag carrier was on the endangered list. Locked in a financially devastating battle for market share at home with Canadian Airlines International and hobbled by a small domestic market, it was destined to become a subsidiary carrier to one of the U.S. giants, experts said.

But that dire forecast could get turned on its head. Against all odds, Air Canada, which last year ranked a lowly 21st among the world's airlines, is suddenly vying to join the ranks of the world's biggest carriers. On Sept. 9, after months of resisting, archrival Canadian finally threw in the towel and agreed to merge with Air Canada. That will give Air Canada a hammerlock on its home market.

`ENVIABLE ROUTE.' Air Canada is also a leading bidder for Continental Airlines Inc. But it faces a powerful new rival. On Sept. 16 a partnership of German giant Lufthansa and investor Marvin Davis matched Air Canada's offer, which could spark a bidding war. If Air Canada's bid prevails, it would become the kingpin in the world's fifth-biggest airline group (table), just behind the proposed alliance of British Airways/USAir and KLM/Northwest.

Air Canada, privatized in the late 1980s, is gambling that it can build a giant from a foundation of three weak carriers. It's an audacious strategy. The two Canadian carriers are hugely unprofitable, and Continental has been in bankruptcy since 1990. The goal, says Chief Executive Hollis L. Harris, who ran Continental for a year before joining Air Canada, is to "ensure that Canada as a nation plays a leadership role in the rapidly changing airline industry."

Easier said than done. But if Air Canada can pull off both the merger and the Continental deal, the trio of airlines would have some major advantages. They "would have one of the most enviable route systems of any airline in the world," says Greg Kaldahl, marketing director at Avitas Inc. It would be a powerhouse in North America, the world's largest airline market. Continental is expected to emerge from bankruptcy as one of the lowest-cost carriers in the hypercompetitive U.S. market. And under an "Open Skies" pact between the U.S. and Canada expected to be reached by yearend, the merged Canadian carriers would get a crucial jump in opening new routes between the two nations.

Air Canada would also be positioned as a major world carrier. Until now, it has been all but shut out of the fast-growing Pacific market. But the addition of Canadian's and Continental's Pacific routes, plus Continental's Air Micronesia, would give it "tremendous service to the Pacific," says Kaldahl. All three carriers now serve Europe. To bolster this presence, Air Canada is talking with major European carriers about an alliance that could include an equity interest in Air Canada.

Continental's board is expected to select a bid within weeks. Most observers say that of the four bids submitted so far, those of Air Canada and Lufthansa are clearly superior. Of the $400 million that Air Canada and its partners, Texas investors Air Partners L. P., are offering, $100 million is equity. Lufthansa's offer is identical. Those bids compare with $25 million of equity in the $350 million bid by Houston investor Charles Hurwitz, and $60 million of the $385 million bid by Houston entrepreneur Alfredo Brener. To prevail, Air Canada may have to increase its bid.

TICKLISH MATTERS. Assuming Continental's board and the bankruptcy court approve Air Canada's offer, the new alliance would have to struggle to reach cruising altitude. British Airways PLC's bid for USAir Inc. "is an expansion from strength," observes Standard & Poor's Corp. analyst Philip Baggaley, while Air Canada is expanding "from a position of weakness."

Air Canada and Canadian lost a combined $315 million on revenues of $5.3 billion last year and dropped another $333 million in the first half. "Horrific is a kind description of their balance sheets," says Steven Garmaise, an analyst at First Marathon Securities Ltd. in Toronto. Air Canada figures the merged airline would have debt of $5.4 billion and equity of less than $600 million.

Harris concedes the merged carrier won't make money until 1994. And Air Canada would be in no position to pump cash into Continental. Instead, it would have to exploit such synergies as combining routes and purchasing. But U.S. restrictions on foreign ownership would prevent Air Canada from merging the carriers, or even dictating Continental's strategy. At least initially, Air Canada would be limited to a 24% voting stake.

Other ticklish problems loom, too. Employees at both Canadian airlines are unionized, but Continental's pilots are not. And Air Canada, which will own 60% of a combined Canadian carrier if the merger wins approval, will be hampered by its political concession to Canadian to maintain both brand names and two operating headquarters.

Air Canada's shot at the big time may fall short. But as Harris sees it, the only alternative was to become a bit player on the world stage. To Harris, that just wasn't acceptable.

             1991 revenue passenger miles
                       Billions of miles
      AMERICAN           82.33
      UNITED             82.29
      USAIR*             73.66
      NORTHWEST/KLM*     71.04
      CONTINENTAL*       68.71
      DELTA              67.34
      *Proposed alliances
      Note: Ranking excludes Aeroflot
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