Merger creates the world’s largest airline

The filing of an anti-trust suit by the US Department of Justice back in August to block the merger of American Airlines and US Airways on grounds that it would eliminate competition, reduce route choices, and raise prices, looked as though it would, at worst, completely derail the merger or, at best, delay the process by several months.

The DoJ’s blocking move seemed to represent a seismic shift in its attitude to consolidation in the US airline industry, which it has generally approved in recent years. It was also in stark contrast to the more relaxed stance of the European Commission, which approved the merger in double-quick time, albeit with minor conditions.

US Airways and AMR Corporation, AA’s parent company, that has been in Chapter 11 bankruptcy protection since November 2011, responded aggressively to the DoJ’s announcement, saying it would mount a “strong and vigorous defence” of its plans for the US$11 billion merger. Both US Airways and AA pointed to the advantages of the wave of consolidation over recent years in the US airline industry that has cut the number of large carriers in the US market from eight down to five, and how the reduction in cut-throat competition had enabled the consolidated airlines to operate more profitably and improve services for consumers.

In explaining its position, the DoJ maintained that it had learned important lessons from the 2008 merger of Delta and Northwest Airlines, and the 2010 merger between United and Continental, and were not convinced that the AA – US Airways merger would improve the lot of consumers further. Assistant Attorney General, Bill Baer, said that both US Airways and AA were in a position to be “competitive, aggressive and successful on their own, and that passengers would suffer if the merger was allowed to proceed”. The DoJ focused on how the merger would affect travellers from Washington’s Reagan National Airport, from which the merged airlines would have controlled 63% of nonstop flights, and on the fact that four US airlines would control over 80% of all US commercial flights.

Baer observed “If this merger goes forward, even a small increase in the price of airline tickets, checked bags or flight change fees would result in hundreds of millions of dollars of harm to American consumers.” He did not, however, rule out alternative ideas to a straightforward merger block, in order to preserve competition.

Faced with the prospect of unpicking what would be a very complex merger, which US Airways and AMR Corporation had been planning for over a year, and a costly and time-consuming anti-trust trial scheduled to start on 25 November, settlement negotiations were initiated to try and break the legal deadlock, and the parties agreed to consult a court appointed mediator.

On 12 November 2013, AMR and US Airways announced that they had settled the litigation with the Department of Justice, challenging the merger. Under the terms of the settlement the airlines will divest 52 pairs of slots at Washington Reagan National Airport and 17 pairs of slots at New York LaGuardia Airport, as well as certain gates and related facilities to support services at those airports. The airlines will also divest two gates and related support facilities at Boston Logan International Airport, Chicago O’Hare, Dallas Love Field, Los Angeles International and Miami International airports. The divestitures will take place through a DoJ approval process following the completion of the merger. As part of the settlement agreement with the Department of Justice, the newly merged airline group has agreed to maintain its hubs in Charlotte, New York (JFK), Los Angeles, Miami, Chicago O’Hare, Philadelphia and Phoenix, in line with its historical operations, for a period of three years. In spite of the enforced divestitures, the new American Airlines Group Inc., as the combined airline will be called, is still expected to generate more than US$1 billion in annual net synergies from the merger, beginning in 2015.

Commenting on the settlement of the litigation and the approval of the merger, Bill Baer said that the airlines’ agreement to divest slots at key airports will allow low-cost carriers to expand and “will disrupt today’s cosy relationships among the incumbent legacy carriers and provide consumers with more choices and more competitive airlines”.

The settlement was approved by the US Bankruptcy Court on 27 November 2013, and Judge Sean Lane advised that the merger should be completed “without delay”. American Airlines and US Airways were planning to close their merger by 9 December 2013.

The US Attorney General, Eric Holder, commenting on the approved merger said:

“This agreement has the potential to shift the landscape of the airline industry. By guaranteeing a bigger foothold for low-cost carriers at key US airports, this settlement ensures airline passengers will see more competition on nonstop and connecting routes throughout the country.”

Etihad builds on its “equity alliance”

In October, the Indian Government approved Etihad’s purchase of a 24% stake in Indian carrier Jet Airways in a US$379 million deal, paving the way for the first foreign direct investment in India’s aviation sector, after the Indian Government relaxed restrictions in September last year allowing foreign companies to hold a stake of up to 49% in Indian airlines.

Indian airlines have struggled for years with high operating costs, poor infrastructure, and heavy losses, but the local aviation market is considered to have huge growth potential, as India’s increasingly affluent middle classes take to air travel. Ajit Singh, India’s civil aviation minister, welcoming Etihad’s investment, said:

“It’s very good for aviation and it may restore the confidence of investors in the Indian growth story.”

Apart from the obvious significance of the deal in terms of the Indian aviation sector, the stake taken by Etihad represents a further step forward for the airline in building what its chief executive, James Hogan, calls “an equity alliance.” Although dwarfed by its Gulf rivals Emirates and Qatar, Etihad, which is wholly owned by the government of Abu Dhabi, has been on a US$1 billion spending spree since 2001, buying up stakes in and lending cash to half a dozen struggling airlines.

It started building its “equity alliance” by buying a 29% stake in loss making Air Berlin, then took a 40% stake in Air Seychelles. Those deals were followed last year by the acquisition of a 3% stake in Aer Lingus and a small stake in Virgin Australia, which it has now built up to a 17.4% shareholding. In August Etihad took a 49% stake in JAT, Serbia’s national carrier, and now it has acquired the 24% stake in Jet Airways. James Hogan says that Etihad’s investments are not purely opportunistic, but part of an overall coherent strategy based on operating out of a Gulf hub, which enables Etihad to fly nonstop to almost any point on the globe.

The Etihad strategy has undoubtedly succeeded in feeding more passengers onto its network, which includes, apart from the “equity alliance” airline partners, 45 codeshare partners serving a virtual network of 350 destinations. Etihad’s annual traffic has grown by 42% over the last two years, to nearly 12 million passengers, with a fifth of all of its revenues now generated by its equity partners.

However, much to James Hogan’s chagrin, parallels are being drawn between the Etihad strategy and the ill-fated Swissair expansion. Swissair collapsed in 2001 under the burden of losses and financial guarantees from minority stakes taken in several troubled European carriers, including the Belgian carrier Sabena. James Hogan firmly rejects any comparison with Swissair: “This isn’t the Swiss model. We won’t step in to other people’s problems. We only invest if we see network cooperation, the ability to take out costs collectively and a good management team.” He says the sun is setting on the era of global alliances, and says that he believes these alliances are being undermined by a growing trend for tie-ups between airlines outside of these alliance groupings. The Etihad strategy is certainly making the industry sit up and take notice, with Hogan winning the Executive Leadership award at this year’s Airline Business’ Airline Strategy Awards; with judges commenting that the Etihad strategy is “shaking up the industry”.

When interviewed, James Hogan remains coy about what future investments Etihad may make. Commentators have speculated whether Etihad will take a stake in Alitalia, or in troubled Polish state-owned carrier LOT, and there is a lot of speculation about whether Etihad will increase its stake in Aer Lingus, if Ryanair is forced to sell off some of its shareholding. Hogan will only concede that he would like to try and expand Etihad’s foothold in the US market.

Aegean-Olympic deal gets go-ahead

The European Commission finally cleared the acquisition of Olympic Air by Aegean Airlines on 9 October 2013, following an in-depth investigation that examined the effects on competition in the affected markets.

Olympic Air was formed in 2009 from the flight operations assets of its troubled predecessor, Olympic Airways, and then acquired by the Greek company Marfin Investment Group. There had been long running battles between the Greek Government and the European Commission over injections of state aid into Olympic Airways, which led to its near collapse. When the Commission blocked Aegean’s previous attempt to merge with Olympic in 2011, the two airlines were providing competing services on 17 routes, nine of which raised competition concerns. Currently, Aegean and Olympic have overlaps on 7 routes, and this time around the two carriers made submissions to the European Commission that only by combining could they achieve the economies of scale to become viable. Both carriers posted losses in 2012 – Aegean, €10.5 million and Olympic Air, €8.6 million, and with the Greek economy in meltdown, and a 26% drop in demand for domestic air passenger transport from Athens, the survival of both airlines looked to be in jeopardy if the merger was not given clearance. One analyst said “The financial crisis in Greece is putting huge financial pressures on both airlines, and therefore it would seem reasonable that the European Commission would prefer to appear to facilitate the survival of at least one Greek airline rather than facilitating a limited domestic competition that could result in both airlines going out of business”.

In April 2013, when it started considering the latest merger proposal between Aegean and Olympic, the Commission said that it would look at “relevant factors such as the Greek economy and the financial situation of the parties”; and it is clearly these factors, and the fact that the market investigation revealed that there is no likelihood of any other airlines competing on overlapping routes or coming in as a new entrant to the Greek market, that persuaded the Commission that they should approve the merger under the EU Merger Regulation.

The Commission’s investigation concluded that Olympic Air would be forced to exit the market in the near future due to financial difficulties if it was not acquired by Aegean, and once Olympic went out of business, Aegean would become the only significant domestic service provider, and would capture Olympic’s current market share. In other words, the Commission determined that with or without the merger Olympic would soon disappear as a competitor to Aegean, and, in those circumstances, applying the “failing firm” test, it concluded that the merger could cause no harm to competition.

Ryanair cut Aer Lingus stake

The UK Competition Commission ordered Ryanair to sell down its 29.8% stake in Aer Lingus to 5% in August, and restricted Ryanair from seeking or accepting representation on Aer Lingus’ board or acquiring further shares in Aer Lingus, on the basis that

“Aer Lingus’ commercial policy and strategy was likely to be affected by Ryanair’s minority shareholding, in particular because it was likely to impede or prevent Aer Lingus from being acquired by, or combining with another airline.”

In February 2013, the UK Competition Commission blocked Ryanair’s third bid to take over Aer Lingus over the last eight years, ruling that the proposed merger would increase fares for passengers and create a monopoly on 46 UK-Ireland routes.

This latest decision by the Commission, ordering Ryanair to cut its stake in Aer Lingus, will perhaps not surprisingly be appealed by Ryanair, who accused the Commission of making “a manifestly unjust ruling”. In the meantime, Aer Lingus is supposedly in ongoing merger discussions with another airline. Internal documents provided to the Commission showed that they considered two possible scenarios in terms of a combination with another airline, but noted that in both cases a shareholder vote would have been required, which would have necessitated Ryanair’s approval of any merger candidate.

No more European consolidation likely in the near term

The big wave of European consolidation over the last ten years appears to have run its course for now with the creation of IAG in 2011 from the merger of BA and Iberia, following on from the Air France merger with KLM back in 2004, and the Lufthansa combination with Swiss in 2005 and Austrian Airlines in 2009.

These three European large flag carrier groups are now focusing on cutting costs, rather than acquiring more airlines, and are busy restructuring their loss-making short-haul operations to try and compete with the low cost carriers. The net effect of this is that the smaller flag carriers like TAP Portugal and Alitalia are potentially left out in the cold, even though they have valuable niche markets and good networks.

The privatisation of TAP Portugal was shelved by the Portuguese Government last December after attracting only one bid, with IAG and Lufthansa deciding against making binding offers.

With its future in the balance, Alitalia remains on the “watchlist”, while Air France-KLM takes time to consider what to do with its 25% stake in the airline, and a recent capital injection of €300 million is being investigated by the European Commission as potential state aid. The Italian Government have made it clear that they would be happy for Air France-KLM to take a larger stake in Alitalia, but have suggested that Alitalia must be integrated into any future foreign owner as an “equal partner”, and that Rome’s Fiumicino airport will continue to be used as a hub. Airline commentators point out that the Italian Government is in no position to set any preconditions to a merger – particularly ones that may make the acquisition of a stake in Alitalia by a foreign airline an unattractive proposition.

Alitalia is a chronically unprofitable airline. In the first half of 2013, it recorded a net loss of €294 million, up from €201 million in the same period last year, and it has not reported a full-year net profit since 2002. Air France-KLM abandoned a full scale bid for Alitalia in 2008, after Silvio Berlusconi, the former Italian Prime Minister, campaigned against a foreign takeover. Alitalia entered bankruptcy protection, and was bought out by Italian investors, who then sold a 25% stake on to Air France- KLM in 2009. Since then, Alitalia has been battered on short and medium-haul routes by strong competition from low cost carriers, and has lost traffic to high-speed trains operating between Rome and Milan.

Alitalia now stands at a crossroads, with its shareholders approving a rescue plan in November backed by the Italian Government that includes a €300 million capital increase, partly underwritten by the state owned postal services group Poste Italiane and two of Italy’s largest banks, Intesa SanPaolo and Unicredit, guaranteeing up to €100 million of shares. Several airlines and airline associations have accused the Italian Government of stepping in to protect the airline again and propping it up with state aid, and the European Commission announced on 26 November that it had opened an investigation into Alitalia’s capital increase, plan to check whether it complies with state aid rules.

Alitalia and the Italian Government have a long history of run-ins with the European Commission over state aid investigations into Alitalia, and they will not welcome a European Commission investigation into this latest rescue plan. The European Commission ruled that capital injections made in Alitalia between 1996 and 2000 were illegal state aid, although they cleared a subsequent recapitalisation in 2005. The Commission also ruled that a €300 million bridging loan made to Alitalia in 2008 constituted illegal state aid, but said that Italy should recover the money paid from the old Alitalia – which enabled the private investors that have established the successor operation to keep the airline going, in spite of an unsuccessful challenge to the Commission ruling made by Ryanair to the European Court.

IAG have complained to the Commission about the latest proposed capital injection into Alitalia, saying that they would “urge and expect the Commission to take interim measures to suspend this manifestly illegal aid”, and Italy’s deputy finance minister, Steffano Fassinia, has waded into the argument, insisting that “the rescue plan is a temporary arrangement” until Alitalia can reach a deal with an international partner. So, unless the capital increase rescue plan is formally approved by the European Commission, and until Air France-KLM comes to a decision on whether to increase its stake Alitalia’s future hangs very much in the balance.

It seems pretty clear that IAG will not step in and take a stake in Alitalia. Following the acquisition of bmi and having taken full control of the Spanish low cost carrier Vueling, Willie Walsh, CEO of IAG, said:

“We don’t see anything attractive to buy or merge with in Europe at the moment. It’s clear there are a lot of airlines in play. Most of these are peripheral airlines that we can’t see adding any value to the IAG group – or in all honesty, adding any value to pretty much anybody. So we don’t have any proposals to do anything.”