After more than a year of negotiations, British Airways (BAY.L) and Iberia (IBLA.F), two of Europe's largest airlines, are finally joining forces. Late on Nov. 12 the carriers agreed to a $7 billion merger that will create the world's third-largest airline by revenues and No. 7 by passenger traffic. Regulators must still green-light the deal, which is expected to be completed before the end of 2010. For the two struggling carriers, the proposed marriage is a high-stakes effort to ensure the viability of their businesses. The global economic downturn has whacked passenger levels—especially for higher-margin business travel—while rising competition for inter-European flights from low-cost carriers such as EasyJet (EZJ.L) and Ryanair (RYA.L) has eroded revenues and profits at both airlines. At the same time, other European flag carriers, particularly AirFrance-KLM (AIRF.PA) and Lufthansa (LHAG.DE), are siphoning off market share for long-haul routes to North America and Asia. Faced with these challenges, BA and Iberia have a stark choice: merge or continue to lose market share and money. The deal will combine British Airways' strength in transatlantic and Asian routes with Iberia's dominance in European flights to Latin America (and a growing presence across North Africa). Annual cost savings from the merger should amount to about $600 million five years after the deal goes into effect, the companies say. "Iberia can't grow on its own, and British Airways is being left behind by Air France and Lufthansa," says a London-based analyst who declined to be named. "This is a make-or-break deal for both of them." Awaiting ApprovalThere are plenty of potential problems that could scupper the merger, though. First and most important, it needs to be approved by the European Commission, which is also currently looking at a plan floated by BA, Iberia, and American Airlines (AMR) to collaborate more closely over schedules, fares, and operations. (The three airlines are already in the same marketing alliance, OneWorld.) The proposed three-way tie-up would be similar to deals already approved between AirFrance-KLM and Delta (DAL) and between Lufthansa and United (UAUA). But in October the European Commission raised concerns over whether a partnership involving American, BA, and Iberia could limit competition. (Authorities have previously shot down two attempted partnerships between BA and American in the past.) Analysts now think the merger of BA and Iberia could worsen the likelihood of an American deal being approved. "The BA-Iberia merger could work against them if regulators think it will limit competition," says an equity analyst who asked not to be identified. The British and Spanish airlines also will have to reconcile two starkly different corporate cultures, especially a large salary gap between BA and Iberia employees. British Airways' pension liabilities, now $4.4 billion—roughly equivalent to the company's total market value—could become too costly to manage. And ongoing labor disputes, including potential strikes by both BA and Iberia employees before the end of year, may unhinge efforts at both airlines to weather the current economic storm. Time Will TellThe merger schedule allows plenty of time to sort out some of these issues. As the plan stands, BA Chief Executive Willie Walsh will lead a new holding company overseeing both British Airways' and Iberia's separate businesses. BA shareholders will own 55% of the new entity, with Iberia's investors holding the rest. A finalized merger agreement is expected during the first quarter of next year, with shareholders set to vote on the deal before the end of 2010. "Everything rests on whether they can achieve costs savings," says Peter Morris, chief economist at aviation consultancy Ascend in London. "The whole aviation industry is declining, so it will be difficult to shrink their businesses back into profitability." Investors weren't impressed by the meager cost savings outlined in the deal, which are projected in 2015 to amount to just 2.7% of the airlines' combined revenues last year. "For a merger of this scale, the cost savings proposed are conservative to say the least," said Chris Mills, a partner at London-based management consultancy PIPC in a statement released after the announcement. In afternoon European trading on Nov. 13, Iberia shares were down 4% and BA's stock was down less than 1%. But while analysts question the potential synergies, BA and Iberia may have had little choice but to combine forces. The British giant, which once ranked as the world's largest airline, fell from record profit to its biggest-ever loss in its last fiscal year ended Mar. 31, and it reported on Nov. 6 that it lost an additional $185 million in the six months ended Sept. 30. Iberia followed suit on Nov. 13 with a $133 million loss for the six months ended Sept. 30, vs. a $77 million profit for the same period in 2008. Both carriers blamed the global downturn in airline traffic and tough competition for the losses. While waiting for the deal to go through, BA and Iberia will have to focus on turning around their declining market share in short- and long-haul flights. Says Ascend's Morris: "Both carriers were perilously poised when the downturn hit. Since then, things haven't got much better."
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