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."
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.
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.
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.
There's speculation that Lufthansa and British Airways could work out a swap, with BA exchanging its Iberia holding for Lufthansa's stake in BMI.
Meanwhile, British Airways itself has become the subject of takeover talk. There's speculation the largest Arab airline, Emirates, may try to buy it.
"That's certainly possible," said Westwood, who sold his British Airways holdings at 5 pounds a share, which is just a shade under its current price. "Emirates is doing incredibly well and expanding rapidly, and I'm sure they would love to get their hands on a great British brand like that."
Elsewhere, Finnair and SAS would be natural partners, if political considerations would allow a tie-up between the Helsinki- and Stockholm-based airlines.
Ryanair Holdings (RYA) launched a bid for Aer Lingus (AERL) shortly after the latter's initial public offering, though that bid has been thwarted by both Aer Lingus shareholder opposition and European Commission competition concerns.
For the most part, the low-cost carriers -- such as Ryanair and Air Berlin (AB1000) -- aren't being targeted by the flagship carriers, though the low-cost carriers themselves could consolidate.
"The low-cost carriers keep out of the way of the flags, and vice versa, for the most part," said Watson. Since the likes of Ryanair fly to smaller regional airports, rivals like Lufthansa wouldn't extract any network benefits from acquiring them.
Too late to buy?
Even amid the M&A chatter, fund managers have been wary of recommending the purchase of shares in European airlines, pointing to the tremendous gains already racked up by such stocks.
Bid target Iberia has rallied 47% this year. From 2003's lows, British Airways shares have jumped sixfold.
Westwood of Threadneedle said he prefers such low-cost airlines asRyanair and easyJet (EZJ) to the merger plays.
"I still favor the low-cost airlines over the former state-owned airlines," he said. "Air traffic is so cheap now, and a lot of regional airports are opening up."
Westwood does acknowledge that airlines may be able to continue to ratchet up fares. With growing emerging-market demand for aircraft, Boeing (BA) and EADS unit Airbus are booked up for years, restricting airlines' ability to add capacity.
"The problem at the moment is that you can't order any new planes," he said. "[British Airways CEO] Willie Walsh will have to wait until 2013 for new planes."
Mellon's Shant invests less in airlines than his fund's benchmarks call for, though he is a fan of Alitalia, he said.
"There's a risk that you're getting involved rather late in the cycle. It's a fascinating space, but one which has proven to be exceptionally cyclical in the past."
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