British Airways and Iberia have signed a memorandum of understanding which aims to merge the two airlines under a new holding company named TopCo. If approved, this will create an airline with 419 aircraft servicing

205 destinations and 62m passengers. The merger is expected to be completed by late 2010 with the overall entity having a value of more than ?4.5bn ($7.4bn) and both airlines continuing to operate as separate brands, but with significant cost savings of E.400m $595m after five years, greater buying power, higher revenue synergies and a much larger route network.

The proposed merger of the two loss-making airlines [talks reported in TREND, July 30, 2008] is entirely dependent on regulatory approval from the European Commission and that of British Airways' and Iberia's respective shareholders, although Air France's merger with KLM in 2004 is likely to provide a solid precedent for the Commission to wave the deal through.

This new 'deal' comes as no surprise considering that the two companies have been talking about various options for over two years. Indeed, it was only two years ago that a consortium including British Airways bid unsuccessfully to acquire Iberia for E.3.4bn ($5bn). BA has also held 'merger' talks with Qantas, although these came to nothing in the end.

On the inflight duty free side, BA currently runs one of the best programmes in the world, which in a good year generates around $140m. On the Iberia side, the inflight contract – worth around $10m a year – is operated by Duty Free World under a five-year contract signed in July 2007.

But this is mere peanuts compared with the E.15bn ($22.3bn) worth of joint revenues that both airlines believe they will generate if the deal is given the green light. Currently, BA already owns 13.5% of Iberia and it already operates a code sharing agreement with the Spanish carrier under the One World airline alliance.

WHAT IT REALLY MEANS
Both parties say that the new agreement 'recognises the principle of parity at board and management level and it is expected to generate annual synergies of approximately E.400m ($595m), and benefit both companies' shareholders, customers and employees. The new group will combine the two companies' leading positions in the UK and Spain and enhance their strong presence in the international long-haul markets, while retaining the individual brands and current operations of each airline.

Under the terms of the proposed merger, British Airways shareholders will receive one new ordinary share in TopCo for every existing British Airways ordinary share held by them and Iberia shareholders will receive 1.0205 new ordinary shares for every existing Iberia ordinary share held by them. On the basis of this exchange ratio, and after cancellation of the treasury shares held by Iberia and prior to the cancellation of the cross-shareholdings held by British Airways and Iberia in each other, British Airways shareholders will hold 55% of TopCo and Iberia shareholders will hold the balance.

TopCo will be a Spanish incorporated company registered in Madrid and the majority of Board meetings and all shareholder meetings will take place in Madrid. TopCo will also be tax resident in Spain, with the operating and financial headquarters of the combined group located in London, with an additional management office located in Madrid.

The TopCo board will comprise 14 directors with seven designated by each airline.

Antonio V?zquez, Chairman and Ceo of Iberia (and a former Chairman of the Altadis Group) said: ‘It has been a long process where many people, both at British Airways and Iberia, have worked very hard to reach this agreement. But in the end it was worth it. This agreement is a giant step in the history of both Iberia and British Airways. We are laying the foundations of what will be one of the most important airlines in the world, a real global airline. I believe that, thanks to this transaction, which is the most important in the European airline industry in recent years, we are more prepared than ever to face future challenges.’

Willie Walsh, British Airways Chief Executive, said: ‘The merger will create a strong European airline well able to compete in the 21st century. Both airlines will retain their brands and heritage while achieving significant synergies as a combined force.’

BENEFITS OF THE PROPOSED MERGER
The British Airways and Iberia boards claim that the principal benefits of the merger include the following:

1. Significant customer benefits: Enhanced customer benefits with a larger combined network for passengers and cargo and continued investment in new customer products and services with more capacity for investing in more and better products and services to customers.

The combined group will offer its customers connections to 205 destinations and strengthen the oneworld alliance. British Airways' customers will gain access to up to 59 new destinations, of which 13 will be in Latin America, while Iberia's customers will gain up to 98 new destinations across the British Airways' network. They will also be offered better frequencies and connections, more competitive prices, access to more VIP lounges and enhanced frequent flyer benefits.

Improved strategic position within the global aviation sector: Highly complementary network fit worldwide, in particular combining British Airways' strong presence in North America, Asia-Pacific and Africa with Iberia's strong Latin American presence.

Greater potential for future growth by optimising the dual hubs of London and Madrid. Enhanced scale and ability to compete with other major airlines and participate in future industry consolidation.

Significant synergy potential: Annual synergies of approximately E.400m ($595m) at budgeted exchange rates are expected by the end of the fifth year after the completion of the merger at a cash cost of up to E.350m ($520.6m). The synergies will be incremental to the existing value from the airlines' joint business between the UK and Spain. Approximately one third of the synergies are expected to be revenue related (joint selling, network and revenue management benefits) with the balance coming from cost synergies in areas such as IT, fleet, maintenance and back office functions.

Strong group management team to maximize the combined group's earnings potential and deliver synergy benefits while maintaining localised operational focus and accountability.

Group Management: The combined business will be led by the group Ceo, Willie Walsh, and a management team chosen equally from each airline. It will comprise of the group chief executive officer and group chief financial officer, the chief executives of the each airline (OpCo), a revenue synergies officer and a cost synergies officer. The group management team will be responsible for the overall direction and strategy of the combined business, delivery of synergies and co-ordination of central functions.

Initially this management team will comprise: Willie Walsh, Group Ceo; Rafael S?nchez-Lozano, Ceo of Iberia OpCo; Keith Willliams, Ceo of British Airways OpCo; Enrique Dupuy De L?me, Group CFO; Robert Boyle, Revenue Synergies Officer; and Jos? Mar?a Fariza Batanero, Cost Synergies Officer.

ASSURANCES
To protect the specific interests of British Airways and Iberia, both stakeholders have provided the following assurances that will last for five years from completion of the merger. These include:

1. Both airlines to keep their main base in their home country with their own licenses, certificates, codes and brands.

2. Slot and destinations will be protected for the benefit of the combined group.

3. The group's network strategy will be developed in a way that reflects the importance of both London and Madrid hubs.

4. There will be a balanced long-term development of the network served from each of the Madrid and London hubs and there will be a reasonable division of opportunities between the two networks.

5. Labour relations will be handled locally.

6. Iberia or TopCo will not provide any guarantee or use any cash or credit facilities to fund the BA pension scheme.

COMMENT: This attempt to create Europe's biggest airline with 62m passengers a year (ahead of Ryanair's 57.6m) is less about passengers and more about survival and shareholders. While the end game may have the best intentions for both loss-making businesses, there will inevitably be job losses at both head offices in London and Madrid as synergies will be sought in senior management, sales, maintenance facilities and even in potential areas such as catering – and ultimately/possibly even inflight duty free.

The ability of both airlines to juggle routes using their two major hubs of London and Madrid – instead of one each at present – will obviously deliver cost savings and there will doubtless be some temptation for both to re-route passengers currently using direct flights via their partners' hubs, so freeing up precious slots at Heathrow and Madrid to add additional flights.

For example, BA could re-route its flights to South America through Iberia's Madrid hub. But there are dangers here, since if this is extensive, it may not prove too popular with regular travellers.

FINANCIALLY CHALLENGED
Then there is the small matter that neither airline is in exactly good shape. BA recently reported a six-month pre-tax loss of ?292m ($486.5m) and it is planning to shed 4,900 employees from its total workforce of 40,000 by March 2010.

This is without even addressing the black hole containing BA's ?3bn ($4.9bn) pension fund deficit. This is so serious that under the pre-conditions of the 'merger' Iberia has retained the right to terminate the agreement altogether if the outcome of discussions between BA and its pension trustees is not satisfactory. This is undoubtedly the single biggest short-term challenge for BA Ceo Willie Walsh.

By contrast, Iberia has 20,000 employees and it made a loss of E.72.8m ($108.3m) between April and June. Both BA and Iberia are also currently in disputes with their unions over pay and contractual conditions, with strike action being threatened by unions representing both airlines' employees in the run up to Christmas.