British Airways, Iberia Agree to Merge

Rising fuel prices and a slowdown in business travel have been twin killers for airline profits. But a couple of European carriers now figure they can soar above the competition by joining forces. After 15 months of negotiations, British Airways and Iberia announced a preliminary agreement on Thursday for a $7 billion merger that would create the world's third-largest airline by revenue. The companies hope to complete the deal by the end of 2010, and BA shareholders would hold 55% of the new firm, with Iberia shareholders holding the remaining 45%. The combined company would have revenues of around 15 billion pounds ($20 billion).

The deal marks the latest merger in Europe’s rapidly consolidating airline industry. In the past year, Lufthansa has taken over or acquired stakes in Austrian Airlines, Brussels Airlines and BMI British Midland Airlines, while Air France-KLM has taken a stake in Italy's Alitalia. These airlines have all been struggling with high fuel prices and fewer bookings—especially the premium business travel fares—and analysts say the industry badly needs to bring its structural costs down. BA, for example, posted a 20% decline in revenues to 4.1 billion pounds in the six month period to September, resulting in an operating loss of 111 million pounds. And the company looks headed for a 400 million pound loss for its full fiscal year, ending in April 2010, according to analyst Tony Shepard at the British brokerage firm Charles Stanley.

Still, the merger could eventually pay off, say analysts. Passenger traffic appears to have stabilized, and airlines have been able to convince their workforces that the industry is in crisis, pushing through some labor concessions and reducing capacity. BA is making “genuine progress” in lowering costs, says analyst Nick Cunningham of Evolution Securities. The company has also recapitalized, following a convertible bond offering over the summer, and now has 1.5 billion pounds in cash. Plus, premium long-haul traffic—where airlines make most of their profit—has started to pick up too. “Put it all together and things are starting to get better,” says Cunningham, who raised his rating on BA to a Buy on Monday.

Rival airlines had a mixed reaction to the deal. Virgin Atlantic—which faces perhaps the biggest threat—said in a statement that the merger will “increase BA's dominance at Heathrow with 44% of takeoff and landing slots this winter,” and added it’s “impossible for any other airline to replicate their scale.” Other rivals say the deal could actually help them win business. Michael O'Leary, CEO of discount Irish carrier Ryanair, told CNBC that the deal was like “two drunks holding each other up on the way home. All you get when you put two high-fare, loss-making airlines together is even higher fares and even bigger losses." O’Leary (who’s known for such flamboyant statements) runs a regional carrier and doesn’t compete on long-haul flights against carriers like BA. And whether he’s right about BA-Iberia’s prospects remains to be seen.

This article is an excerpt from our Early Bird markets story, which was originally published the morning of Nov. 13.