British Midland Triggers A Storm In Europe's Skies

The Lufthansa deal threatens BA's dominance

At first, it doesn't look like a big deal: On Nov. 10, Lufthansa bought 20% of British Midland, Britain's No. 2 airline, for $148 million. But the alliance that results could trigger a storm in Europe's skies.

The agreement formally puts Midland into the camp of the Star Alliance. This potent grouping includes Lufthansa and United Airlines of the U.S., as well as Scandinavian Airlines Systems (SAS), which is selling the stake. Midland had stayed out of Star before. Now, by joining the group, Midland hugely expands its opportunities for joint marketing with some of the world's biggest airlines. In return, Star gets a major position at London's Heathrow Airport, the prime European hub, where British Airways has reigned supreme. The deal will pump up Star to a respectable 27% of Heathrow takeoff and landing slots, compared with BA's 38%.

This is just the kind of aggressive flanking maneuver BA doesn't need. On Nov. 8, the beleaguered BA reported a more than 80% drop in profits for the quarter ending Sept. 30, to $65 million. BA is in the middle of a wrenching change of strategy. Now it has to worry about the Trojan Horse effect of the Midland deal as well. Indeed, Lufthansa CEO Jurgen Weber says the pact means Star can establish a second European hub at Heathrow. In an apparent dig at BA, which has clashed with the European authorities, he praised Midland for not going in for "big talk and jingoism."

Lufthansa's terms give a putative market value of nearly $750 million--more than 40 times 1998 earnings--for privately held Midland. But this seems to be a long-term move. Lufthansa, observers say, is looking ahead to a time when further deregulation will allow more consolidation of Europe's airlines. The deal with Midland could be a step toward bringing both Midland and SAS under Lufthansa's ambitious wing in a full merger.

But the winner for now is Sir Michael Bishop, a devotee of Gilbert and Sullivan comic opera who is Midland's chairman and controlling shareholder. Although Bishop didn't get cash from the deal, he is said to have gotten good terms for splitting the take from Heathrow operations with Star.

Bishop doesn't enjoy as much publicity as Richard Branson, the maestro of Virgin Atlantic. But he has long been one of BA's most effective antagonists. Since the 1980s he has built Midland into a successful European and British domestic airline, largely at BA's expense. He has been turning up the heat, applying for a transatlantic license and launching a "Make the Air Fair" campaign highlighting the lack of competition on Heathrow-North America routes.

SELL OUT? The dogfight with BA has hurt Midland's profits, which ran at $18.2 million last year on revenues of $922 million. But Midland's value is the network it has built up--especially the hefty 14% of the takeoff and landing slots it controls at Heathrow. The Star partners want to make sure they control those slots and Midland's 6 million customers per year. Bishop says that a flotation of closely held Midland is now one of the options for the future. But judging from the latest transaction, he would likely get a better price by selling out to Lufthansa or other Star partners.

Analysts are now wondering whether Star's enhanced position at Heathrow will change the way regulators look at the competition picture. Authorities on both sides of the Atlantic have effectively killed a proposed tie between BA and American Airlines, citing BA's dominance at Heathrow. The two have had to settle for a looser association.

But the power shift at Heathrow could justify a new push for a deeper BA-AA partnership. The Midland deal, says Chris Avery of J.P. Morgan & Co. in London, "will bring the subject of a BA-American alliance back to the boil again with, for a change, BA not being the abuser of market power." Maybe. But in the meantime, BA must watch its back.

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