Europe's Midsize Airlines Are Getting Squeezed

As carriers such as Iberia lose altitude to cut-rate competitors, they also face takeover threats from high-flying giants like Air France-KLM

Europe's big airlines are flying high. After weathering a drop in travel after September 11, 2001, ticket sales at the continent's major long-haul operators and low-cost carriers are soaring thanks to strong economic growth and expanding demand from domestic travelers. According to the European Airlines Assn. (AEA), the passenger load factor in Europe, or percent of occupied seats, has now reached 76.5%, up nearly 6 points since 2001.

It's a different story, though, for midsize airlines such as Spain's Iberia (IBL.F) and Italy's Alitalia (AZPIA.MI). Squeezed between more powerful and profitable giants Air France-KLM (AKH), Lufthansa (LHAG.F), and British Airways (BAY.L) and the growing crop of discounters led by Ryanair (RYAAY) and easyJet (EZJ.L), their markets and margins are under attack. "The midsize airlines will continue to struggle without being part of a strategic alliance or another larger carrier," says Peter Morrell, research director at Cranfield University's Air Transport Dept. in Britain.

Stuck in the Middle

The contrast in results is stark. Lufthansa, Europe's second-largest airline, posted a $595 million profit in the quarter ended June 30, up from $248 million a year earlier, on revenues up 3.7% to $7.4 billion. By contrast, Italian legacy carrier Alitalia turned in a $179 million loss for the quarter ended Mar. 31—the most recent for which it has reported—despite revenues up 7.4%, to $1.06 billion.

Iberia is stronger, thanks to its powerful route structure to Latin America. On Aug. 14 it announced record occupancy rates and quarterly profits of $85 million on revenues off 2.6%, to $1.77 billion. But Air France-KLM is increasingly nipping at its heels with flights from Paris and Amsterdam to Latin America. For now, Iberia remains ahead with a 20% market share, but the Franco-Dutch carrier, which posted $571 million in secondquarter profits, now boasts 17% of the market.

At the other end of the market, low-cost carriers continue to gnaw away at midsize carriers' intra-European business. Ryanair and easyJet, the continent's biggest no-frills airlines, both recently announced double-digit annual revenue growth due to rapid expansion across the continent (, 07/31/07 "Ryanair Flying High").

Takeover Targets

No wonder, then, that takeover speculation continues to swirl around Europe's midsize airlines. A British Airways-led consortium including private equity firm TPG (formerly Texas Pacific Group) already has offered nearly $5 billion for Iberia, and Air France-KLM also is reportedly interested in buying the Spanish airline (see, 03/30/07, "Texas Pacific Mulls an Iberia Bid".

With its leading position in Latin America, Iberia is especially attractive to British Airways, which already owns a 9.9% stake in the company and is looking to expand its presence in the Americas. "It would be advantageous for Iberia to have a stronger partnership with one of the big three European carriers," says Leigh Bailey, airline analyst for Standard & Poor's, which like BusinessWeek is a unit of the McGraw-Hill Companies (MHP). "BA has the advantage because they have had a long-standing alliance with Iberia."

While the Spanish airline would offer competitive advantages to Europe's larger airlines, the same can't necessarily be said for Italy's beleaguered Alitalia, which has suffered several setbacks since the government announced the planned sale of its 49.9% stake in the company at the beginning of the year (see, 02/14/07, "Alitalia: Who Wants This Airline?")

All of the potential bidders dropped out after Rome placed severe conditions on any takeover bid, while concerns over problems with unions have also scared off suitors. The company's workforce has balked at any future job cuts and costly pension outlays have hurt the airline's profitability. "Alitalia is one of the last old-school national carriers," says analyst Les Wheel at London-based airline consultancy Ascend. "Until they figure out the union issues, bidders will be scared away."

Can't Afford to Stand Still

With so much competition, the one thing Europe's midsize carriers can't afford to do is stand still. Some are looking to fill gaps in the market left by the long-haul carriers: Britain's BMI, for instance, bought British Mediterranean Airways for $60 million in February to expand its presence in the Middle East and Africa and now offers flights from Britain to 17 destinations including Cairo and Riyadh. Using its lucrative slots at Heathrow airport, the company hopes to fill niche markets that are too marginal for larger airlines, but too far afield for low-cost carriers.

Others, however, have failed to react. Greece's national carrier Olympic Airlines has been plagued by uncertainty after the European Commission accused the Greek government in 2005 of subsidizing the loss-making airline. Athens has consistently failed to find a buyer for Olympic, which has seen its core business savaged by rival low-cost carriers.

Similarly, Austrian Airlines (AUAV.F) posted a $3.9 million loss in the first half of 2007, although the company is now trying to turn things around by targeting Eastern Europe and the Far East. "Olympic and Austrian Airlines are some of the most vulnerable airlines to the changes in the industry," says Ascend's Wheel. Lufthansa, which bought Swiss (the remnant of collapsed Swissair) in 2005, has repeatedly expressed interest in acquiring Austrian. But industry and private equity buyers continue to steer clear of Olympic and its financial woes.

Expect More Consolidation

Midsize carriers also face particular peril if there's a future downturn in Europe's economy. According to the AEA, passenger traffic on European airlines rose 4.2% in June year-on-year, while traffic within Europe grew 4.9%. Such expansion has helped to mask the increasing financial woes of smaller carriers, but no one expects this growth to continue forever. "It's always easier to make money when the economy's going well, but the future for these airlines will depend on how they respond to a slowing economy," says Cranfield University's Morrell.

One certainty is that there will be further merger and acquisition activity in the sector. Spanair, Spain's secondlargest carrier, already is up for sale by its parent company, Scandinavian giant SAS (SAS.ST), and though a denouement isn't expected before the fall, BA and Air France could well move on Iberia and Alitalia, respectively. One way or another, industry experts figure the European airline industry soon could be dominated by just three global giants plus a cadre of nimble discounters. Midsize national carriers could soon go the way of free peanuts.

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