Flying Duo: British Airways and Iberia

GOOD MORNING. Stocks in Asia closed mixed today; U.S. futures are pointing to a higher open.

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 that latest merger in a 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.

IN OTHER NEWS:

Should the Fed have prevented the housing bubble? Charles Evans, president of the Federal Reserve Bank of Chicago, will try to answer this question in a panel discussion with French central bankers at a conference in Paris today. With one in five US mortgages “underwater” because homeowners owe more than their homes are now worth, the answer might seem obvious. We asked three economists to weigh in on a central bank’s role in preventing asset-price inflation.

Keith Hembre, chief economist at First American Funds: The Fed has given the do-nothing approach a try, and it hasn’t worked so well, says Hembre. “The [Alan] Greenspan doctrine on the subject was that you can’t identify bubbles in real time, so the best approach was to utilize policy to mitigate the aftermath,” he says. Central bankers can’t definitively prove a bubble is inflating in real time, but they can come close by comparing current prices to longer-term trends to see if prices are justified by fundamentals – and even cautious action could have avoided some of the damage from the tech stock or housing bubbles, concludes Hembre.

Robert Brusca, chief economist at Fact & Opinion Economics: As damaging as they can be, trying to prevent bubbles may be the wrong approach for a central bank, says Brusca. “There are episodes in which asset markets can advance strongly that aren’t bubbles,” and overly aggressive action could stifle real growth. The Fed’s role should be to examine the data, look for evidence of fraud or speculation, and “provide information to the markets about what’s going on,” Brusca adds.

Doug Roberts, chief investment strategist at Channel Capital Research: Even if you believe preventing bubbles should be part of the Fed’s role, it may no longer have the right tools for the job, says Roberts, the author of “Follow the Fed to Investment Success.” He believes that globalization turned the Fed into the world’s central bank--but without the power to regulate the world’s financial institutions. A global economy requires global mechanisms for dealing with crises, he says, “otherwise it keeps taking larger and larger amounts of ammo to defuse these things.”