A Wave of Airline Mergers May Be on Europe's Horizon

Ownership restrictions, stubbornly high fuel prices and mounting competition haven't quelled demand for ownership of European airlines, with numerous potential buyers lurking -- from the U.S. to Qatar to Russia.

LONDON (MarketWatch) -- When the Spanish airline Iberia announced last week that TPG Capital had made a tentative $4.5 billion takeover offer, the airline wasn't being completely truthful.

TPG Capital -- better known by its former name, Texas Pacific -- can't buy Iberia (014720003) . That's because the buyout group is American. Even assuming "open skies" changes are ratified by the U.S. Senate, Americans can only own 49% of European airlines, according to rules set up by the U.S. and the European Union.

European airlines also run into restrictions when trying to buy rivals.

Neither Air France nor Holland's KLM, obviously, is American. Yet, after three years under a joint holding company, Air France-KLM (AKH) (003112) , the airlines still run their day-to-day operations separately.

This is partly to placate the French and Dutch governments and their own employees, but running the airlines separately also protects their rights to fly to international destinations without fear exposing themselves to demands for renegotiation. Were the airlines to operate as one company, for example, China could revoke KLM's rights to fly between Amsterdam and Hong Kong.

Lufthansa (823212) and Swiss have a similar set-up under which they operate separate airlines under a single holding-company structure.

Yet ownership restrictions, stubbornly high fuel prices and mounting competition haven't quelled demand for ownership of European airlines, with numerous potential buyers lurking -- from the U.S. to Qatar to Russia.

Foreign demand for European airlines is so strong that Air France-KLM twice has warned overseas investors it would take unspecified action if they bought up too many of its shares, for fear of breaching foreign-ownership rules.

Lufthansa also has warned foreign investors, such as the fund manager Alliance Bernstein and the operator of New Jersey's public pension program, about the dangers of holding overly large stakes.

Europe's top airlines are also in the game. British Airways (BAY) (BAB) , Lufthansa and Air France-KLM are all looking around at rivals, according to published reports.

The open-skies regime, which will make it easier for European airlines to fly routes to the U.S., and soaring private-equity interest are stirring up consolidation talk, observed Mark Westwood, a fund manager at Ameriprise Financial-owned (AMP) Threadneedle Investments. "Those are the two triggers," he said. "It's very early days, and all we can do is wonder what might happen."

Reg Watson, an investment director for Standard Life Investments, an arm of Edinburgh, Scotland-based insurer Standard Life, said previous restrictions led to the creation of more airlines than needed in Europe. "There are far more airlines in Europe than can be reasonably sustained," Watson said. "The gains from consolidation are network benefits and cost cutting."

Losers' curse

Watson explained that by buying an airline -- say, KLM -- carriers get more hubs through which to direct traffic. "If you're taking customers to New York, [Air France-KLM] can go through Amsterdam's Schipol or Paris' Charles De Gaulle."

In the case of Iberia, British Airways already has that capacity; it holds a 10% stake in Iberia, and both are members of the OneWorld alliance. British Airways, which has right of first refusal should any outside company seek to buy another 30% of Iberia, has hired UBS to provide advice.

Valuationwise, British Airways would struggle to justify offering much more than what TPG has put on the table. "But the alternative is not to have Iberia, which would be far worse," said Watson, as British Airways would lose the ability to route flights via Spain.

Air France-KLM and Lufthansa face similar choices.

Air France-KLM currently ranks second in market share on routes between Latin America and Europe, at 17%, compared with Iberia's 19%, so buying Iberia would put the joint venture in a strong competitive position. Lufthansa would stand to boost its presence in Latin America and its ability to feed traffic from Northern Europe.

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