In 2004, when French flag carrier Air France and its Dutch counterpart KLM merged, it was the first major European airline merger in decades. Despite some initial skepticism from investors, the resulting company has realized much of the potential that had originally prompted the merger. Over the past year alone, operating profits rose by 32.5 percent on a 7.6 percent increase in revenues. Similarly, in 2005, German flag carrier Lufthansa merged with SWISS (Swiss International Air Lines), which had emerged from the bankruptcy of Swissair soon after the September 11, 2001 (9/11), terrorist attacks. So far, Lufthansa and SWISS have also each shown strong results.
Yet despite the benefits each of these new entities has reaped since its merger, there has been virtually no other M&A activity in the European airline industry for more than a decade. Any other sector would have begun to consolidate years ago, given the challenging economic environment in which airlines around the world have found themselves since 9/11 — marked by lower consumer spending, customers’ increased reluctance to fly due to security concerns, and corporate cost cutting that has reduced business travel. Even the European airline industry’s successful results in 2007 hide serious problems. Altogether, the industry took in an estimated €3 billion (US$4.4 billion) in operating profits (after taxes and interest), compared with cumulative operating losses totaling €2.8 billion ($3.7 billion) between 2000 and 2006. Yet that €3 billion breaks down to an average of just 4 percent of a typical airline’s revenue, significantly below the 7 to 8 percent usually required merely to cover the cost of capital. Worse, rising fuel prices and the mounting global credit crisis will likely make it difficult to maintain even those slim profit margins. Indeed, the industry’s trade association, the International Air Transport Association, adjusted its profitability outlook for its members three times between June and December 2007, lowering estimates by a total of around 50 percent, and is predicting a further slowdown in 2008, citing jet fuel prices and the risk of the U.S. economy falling into recession.
Given the challenges of maintaining profitability, why haven’t other carriers followed Lufthansa and SWISS and Air France and KLM down the merger path? The reasons are twofold: Flag-carrier airlines operate in a political and cultural environment that is hostile to deal making, however economically rational the deals may be. And even as the European Union continues to push for more mergers, tensions remain between EU rules and the policies of national governments. One issue, for instance, is whether flag carriers at risk of bankruptcy should continue to receive national subsidies — a primary cause of the recent breakdown in merger talks between the Air France KLM Group and Italy’s Alitalia.
We expect the picture will change soon, however. Two major factors are now producing the conditions that will make merger activity much more likely. And that, we believe, offers potential to create a significantly more stable and profitable future for the industry.
The first factor is the worsening economics of the airline business, due primarily to high fuel prices. Fuel makes up more than 30 percent of the average airline’s costs, and as prices continue to skyrocket, every airline will be searching for ways to reduce expenses. When it comes to lowering costs, the major flag carriers have an advantage thanks to their long-term development of economies of scale and the efficiency of their hub-and-spoke systems. Indeed, because of productive global alliances made in the 1990s and their more recent acquisitions, the three leading European airlines — British Airways, Air France KLM, and Lufthansa Group — now boast a market share of 47 percent of the passengers carried by European flag carriers.