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BA’s Global Ambitions Prepared For Take Off

Posted in Airline News, British AirwaysNo comments

Remember this? “It was a calculated risk.”

That was Willie Walsh in May, telling MPs on the Transport Committee why he had pressed ahead with opening Heathrow’s Terminal 5 – even though he knew the building was not fully ready.

Fast forward seven months and the former pilot now running British Airways is once again playing the percentages game. Trained from the cockpit to think in three dimensions, Mr Walsh has brought a similar mentality to the BA boardroom.

This week it emerged that the UK flag-carrier is in merger talks with the Flying Kangaroo, the Australian airline otherwise known as Qantas. The surprise is that this comes on top of two other putative deals.

Since July, BA has also been trying to negotiate an all-share merger with Spain’s Iberia, while badgering the regulators for anti-trust immunity for a revenue-sharing tie-up with American Airlines. All four carriers are partners in the Oneworld alliance, co-operating on routes around the world.

Risks abound. The risk that, by pursuing a trio of deals simultaneously, Mr Walsh ends up with no deal. The risk that, in his enthusiasm to find a partner, Mr Walsh draws attention to BA’s own weaknesses. The risk that he takes his eye off the ball just when recession and volatile oil prices have sent the whole industry into a tailspin. Even the personal risk that he lands one or more deals – but at the price of his own job.

For Mr Walsh, these are calculated risks because, as US astronaut Jon McBride once put it: “A pilot who doesn’t have any fear probably isn’t flying his plane to its maximum.”

The maximum for Mr Walsh is the creation of the first global super-carrier. He has never made any secret of his desire for BA to play a starring role in the overdue consolidation of an industry fraught with anachronistic regulations, notably around ownership and flying rights.

Neither has he hidden the extent of his ambitions. Back in October 2007, when BA was previously tilting at Iberia as part of a consortium with private equity house TPG, Mr Walsh pointed out presciently: “Iberia is very interesting to us but it’s not transformational.”

Qantas would be. As Dresdner Kleinwort analyst, Andrew Evans, pointed out: “Strategically, BA appears to want to lead the way in global consolidation after lagging both Air France and Lufthansa in European consolidation.”

Mr Walsh is adamant he can complete both the Iberia and Qantas mergers but nobody really believes he can do both simultaneously – particularly when there are so many regulatory constraints.

More important, it is also the view of Fernando Conte, Iberia’s chairman and chief executive. Mr Conte could not disguise his displeasure last week at the way Mr Walsh sprung the Qantas talks on him just an hour before they were announced. He has summoned Mr Walsh to a meeting to explain exactly what they had been talking about for the past six months. Mr Conte said: “I think it’s more reasonable to start the [tie-up] process within Europe and then the next step should be between continents.”

Like it or not, one of the two mergers must be done first. So which one? As an intra-European deal Iberia takes the Air France/KLM route map. BA already owns 13pc of Iberia; Iberia 9.9pc of BA. Merging the two brings more initial scope for cost cuts and delivers BA access to Iberia’s 20pc share of the Latin American market – and £2bn gross cash.

Four years after the merger, Air France/KLM is on track to deliver synergy benefits of around £600m this year towards an eventual target of €1bn (£870m). Their hubs are closer geographically than BA’s Heathrow and Iberia’s Madrid base. But a read-through from Air France/KLM implies £400m-£500m of annual cost savings for BA and Iberia.

There are two major stumbling blocks, even before the knotty question of who runs the show. These are: valuation; and BA’s ballooning pension deficit.

When the Iberia talks were first announced in July, BA envisaged taking 65pc of any combined carrier. Now the market capitalisations are suggesting something closer to a 50:50 deal – not least because of the £13bn of final-salary pension liabilities in the BA hold, which look more like a ticking time-bomb in these falling financial markets. Mr Conte admitted last week that he still hadn’t got his head round the issue.

Says one observer: “BA and Iberia have been talking for six months and they haven’t apparently got anywhere. Conte probably thought he had a free run at BA, but he’s taken a long time.”

The momentum appears to be with the Blue/Red deal – code names for BA and Qantas. No one could ever suggest that Aussies and Poms speak the same language, but culturally BA/Qantas is a better fit – not least given that Mr Walsh and Qantas’ new chief executive Alan Joyce are two Irishmen who know each other from Aer Lingus days.

Qantas would bring BA instant exposure to the faster-growing Asian markets and more flexibility to combine fleet – though, thanks to the distance, fewer upfront cost-savings. Analysts are pencilling in, say, £280m initially or around 2pc of the combined cost base.

On valuation, the two airlines are closely matched – though BA is currently valued at around £200m less than Qantas’ £1.9bn, which begs the question why BA wants to lock in a deal at a cyclical low. For much of the last five years, a more natural split would be 55:45 in favour of BA. But, thanks to its exposure to its main US market, BA’s earnings are much more volatile than those of Qantas.

Qantas’s own final salary pension scheme has less than £1bn liabilities. But a bigger problem is structure. Qantas must be at least 51pc Australia-owned and have an Australian chairman. This partly explains why the pair envisage a dual-listed company. Both carriers would retain their separate stock market listings and existing flying rights, but have a top board with “overlapping directors” – six each from both airlines, three of whom would also sit on the other carrier’s nine-strong board.

Early indications are that Qantas chairman Leigh Clifford would chair the combined board, with Mr Walsh chief executive and Mr Joyce in some sort of chief operating officer role – but that could change.

The risk is deadlock on the combined board if BA and Qantas directors disagree. If that happens, there is a nuclear option – for shareholders to break the deadlock with a vote or to oust directors. That’s no way to run a company, though.

Mr Walsh would do either deal first. Some analysts reckon it would be easier to integrate Iberia after Qantas rather than the other way round – though another complexity is that Mr Walsh has made his application for the American Airlines tie-up in co-operation with Iberia.

Mr Conte made a good point this week. In the last 60 years, airlines have generated $11,000bn (£7,500bn) in revenues but just $32bn net profits. Even in the context of that dismal financial history, Mr Walsh reckons “we are in the worst trading environment the industry has ever faced”. Such an environment is brutally unforgiving.

Says John Strickland, director of aviation consultants JLS Consulting: “I rate Willie Walsh highly but he’s taking on an awful lot. The thing about the airline industry is there are so many things that can come up from behind and whack you.”

That, perhaps, is the biggest risk of all.

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