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.

So why is private-equity house TPG interested in Iberia when there are no network benefits or cost savings to be won?

"I wonder if they see themselves as a kingmaker," Watson said. "They may have one eye on the entry price, and one eye on the exit price, and, with three airlines desperate, you can go in and sort it out."

The equity firm does have expertise in the airline industry, having agreed to buy Australia's Qantas and having successfully brought Continental Airlines (CAL) out of bankruptcy in the 1990s. But Iberia is far from bankruptcy -- it's been profitable for about a decade -- and the Spanish airline itself has been trying to wring out costs.

Raj Shant, who runs a fund investing in Continental European stocks for Mellon Bank, pointed out that TPG is also a bidder for Alitalia, and the buyout group's co-founder, David Bonderman, is chairman of Ryanair Holdings (RYAAY) , which has bid for fellow Irish carrier Aer Lingus.

"Somewhere along the line Bonderman clearly sees value," he said. "The kingmaker theory has plausibility, and integrating airlines has plausibility. But [the bid is] not random, and it's not due to excess funds."

Deutsche Bank analyst Chris Reid pointed to another dimension of the Iberia bidding: European airlines, if they want to grow, don't have much alternative.

British Airways has publicly criticized the proposed open-skies liberalization, which won't let it buy a U.S. carrier or operate domestic U.S. flights.

"We believe British Airways is primarily interested in global rather than European consolidation, but we have so far seen only a degree of global market liberalization in aviation and do not think the legal and regulatory framework for a managed global deal is yet in place," Reid said in a note to clients.

Cost-cutting potential

With mounting fuel bills and demanding unions, consolidation can help airlines trim costs.

Mergers have been more successful at generating cost savings than looser affiliations, like OneWorld or Star Alliance, pointed out David Stewart, principal at aerospace consultancy AeroStrategy.

"The members of some alliances are just getting around to buying fuel together," he said. "They haven't been able to do more because they can't agree on common standards for uniforms, fleets or even paper cups."

Air France-KLM has estimated that by fiscal 2011 it may generate 1 billion euros of synergies from combining the two airlines.

"They're really trying to work together, particularly on things like maintenance," Stewart said.

Fund manager Westwood pointed out that deals between KLM and Air France and between Lufthansa and Swiss came at the bottom of the cycle. "Swiss was going bust, so the unions couldn't kick up a fuss," he said. "It's a lot harder now to force through aggressive cost cuts."

Other airlines in play

In Italy, Alitalia (AZA) is up for grabs, with the Italian government shopping its 49% stake in the loss-making carrier.

Officially, there are three bidders in the running for the government's stake, including a consortium in which Russian airline Aeroflot and Italian bank UniCredito (UC) are partners.

"Though there seems to be an element of projecting economic power internationally, buying a Western European flag carrier means more landing rights across Europe and onto the U.S.," said Mellon's Shant of the Russian airline's interest. Aeroflot's interest "may not be entirely down to noneconomic considerations."

Air France-KLM and Lufthansa, however, lurk over the Alitalia bidding, with many expecting one of those Western European giants eventually to buy the Italian carrier, despite declarations that they're not interested.

Also in play is BMI, the U.K. carrier that possesses important landing rights at London's Heathrow. BMI is majority-owned by its chairman, Michael Bishop, with Lufthansa owning 30% minus one share and SAS (SAS) owning the remaining 20%. It holds 12% of the landing slots at Heathrow, Europe's busiest airport.

This Wednesday, BMI said it was looking to forge closer ties with United Airlines (UAUA) but also has been reported to be a buyout target of British Airways, Virgin Atlantic and Lufthansa.

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