The Hawks Are Ready To Strike

BA-KLM could be just the first cross-border deal

After a year of flying low--with operations deep in the red and a badly damaged stock price--British Airways PLC is struggling back. Over the past few months, it has dumped Chief Executive Bob Ayling and replaced him with Rod Eddington, a well-regarded Australian airline executive. Now, with 50-year-old Eddington at the controls, BA is embarking on a gambit that could break down the biggest barriers in the airline industry. On June 7, BA announced that it is in talks with Royal Dutch Airlines (KLM) that could lead to a takeover of the carrier.

If the talks succeed, the combination would create one of the world's biggest airlines, with $19 billion in revenues and 56 million passengers a year-- hefty even by U.S. standards. But more than this, a BA-KLM merger would produce the first major cross-border combination in the business. And that would give a hefty shove to consolidation among the world's airlines, which has so far proven painfully slow. Says Corne Zandbergen, an airline analyst at brokerage Mees Pierson in Amsterdam: "You only need one brick to fall out of the wall for the process to really get started."

Mergers such as the proposed BA-KLM are tricky to pull off. Indeed, BA and KLM tried and failed to merge eight years ago. But good chemistry among senior execs and a shared management approach improve the odds. Even if the talks falter, other European carriers are bound to try something just as ambitious. They realize that deregulation and a single market mean that a dozen or more national carriers cannot continue to compete and survive; the realistic number is probably closer to four. And if U.S. regulators give the green light to the United Airlines Inc.-US Airways Group Inc. combo, more consolidation will follow in the U.S., putting pressure on the European Union to authorize a wave of big-time mergers, too.

More broadly, industry execs say, the loose global alliances among U.S., Asian, and European carriers formed over the past few years have never quite paid off. Many airlines are thinking of swapping partners; others are talking about new regional and global combos. The BA-KLM talks are sure to advance this search for equilibrium across the industry.

The antiquated ownership structure among European carriers is already showing signs of crumbling. Swissair has been gradually buying up Belgium's national carrier, Sabena, taking its stake to 85%.

Lufthansa, BA's toughest rival, could opt for outright takeovers of its alliance partners SAS and Austrian Airlines. On another front, the German carrier could also up the 20% stake it bought last year in British Midland, one of BA's domestic competitors. Swissair, in addition to its interest in Sabena, recently bought Air Liberte, a French domestic carrier, from BA. Swissair could even tie up with KLM if the BA talks fail. And Air France may need a deal of its own.

KLM had sought a deal with Alitalia before turning to BA. But those talks fell apart in April over executive issues and Milan's status as a hub. That left KLM in a jam. CEO Leo van Wijk had already acknowledged that KLM is too small to survive independently and needs a larger partner. And BA was also seeking solutions for its money-losing European operations.

BA and KLM used to be among Europe's premier airlines, with seemingly unassailable positions in ferrying passengers between Europe and the U.S. But Lufthansa, Air France, and Swissair have lowered costs and extended their routes, forcing big cuts in the fares BA and KLM can charge on European routes, which feed profitable long-haul flights from London and Amsterdam. Discounters such as Dublin-based Ryanair have also hurt. BA's loss for the year to Mar. 31 was $366 million before gains from disposals. KLM earned only $3.6 million before extraordinary items, on sales of $6.1 billion, in the same period.

In the face of such shifts, BA's post-merger strategy is already evident: KLM would provide a third major hub at Schiphol Airport near Amsterdam to go with BA's Heathrow and Gatwick operations. Along with realizing economies by combining front offices, reservation systems, and operations, says an informed source, BA may also shift much of its economy-class traffic to Schiphol, which has better transit facilities than Heathrow. Schiphol is also more suited than Heathrow to expansion of the airline's cargo business. At Heathrow, BA would concentrate on handling business-class passengers, who pay much more.

The U.S. dimension to BA's thinking is less certain. BA is part of the Oneworld alliance with American Airlines Inc. KLM still has a linkup with Northwest Airlines Corp. If American buys Northwest, the pieces of the puzzle might fit comfortably together. But if American's eye wanders over to Delta Air Lines Inc., the friction among all these players could be considerable. American has already irritated BA by forging links with Swissair. Regulators on both sides of the Atlantic might butt in, too: They have already blocked efforts of BA and American to develop even closer ties.

DOWNSIDE. Worries about the U.S. may be one reason that not everyone thinks BA's pursuit of KLM is wise. BA's stock fell 5% on June 7, while KLM's has risen sharply since rumors of the talks emerged. Analysts also worry that BA will pay too much and that buying the Dutch carrier will leave BA's problems untouched. "This doesn't bring BA a strong passenger base or a sizable home market," says a London investment banker. Some analysts think BA would be better off pursuing an alliance with a carrier such as Air France--with which it has had talks recently.

As a cross-border deal at the top of the industry, a full merger would require some imaginative thinking. But just by attempting it, BA and KLM stand to advance a consolidation process in the industry that needs nothing more than a final push.

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