Skies are limited for flag carriers

Consolidation and deregulation may save some airlines – but not all

One thing is certain, in five years, the airline industry will have changed markedly. Falling passenger numbers, rising costs and an economic downturn are the main threats in the wake of the terrorist attacks on the US. There will be winners and losers among the airlines, as once-stable national flag carriers are bought, merge or, like Swissair and Sabena, go bust.

"The airline industry will be very different to what it is now," says Daniel Solon, an aviation expert at the research group Avmark International. "We are almost certainly going to see major consolidation in the industry in Europe and globally.

"My guess is that Europe probably will shape down to somewhere between four and six major airlines. I would include a couple of low-cost airlines – probably Ryanair and easyJet," he continues.

The low-cost carriers have hardly been affected by the aviation crisis, as they run services between European cities that have not been unduly disturbed by the turmoil in the US. Ryanair and easyJet say their passenger numbers are back to normal after the attacks – easyJet even reported a year-on-year increase in passengers last week. This is in stark contrast to Air France and BA, which reported significant falls in business.

The low-cost carriers may be highly regarded by the City at the moment but not all the companies concentrating on the upper end of the market are doomed. The odds are on Air France and Lufthansa, the German and French national carriers, to brave the storm and emerge victorious.

"[The winners] will be airlines within major economies, starting with Germany and France, then possibly KLM [the Dutch airline]," Mr Solon says. The outlook for BA is not so certain. Even before the US attacks, it was downsizing and focusing on business passengers and was predicted to make a loss this year.

The airlines will not be forced to consolidate with a gun against their heads. For some time, major carriers have wanted to merge and acquire internationally. BA wanted to wed KLM but the proposed merger fell apart a year ago.

One of the stumbling blocks for that deal, and any future inter-European deal, is that governments negotiate who will fly in their air space on a country-by-country basis. "The underlying reason on why there has not been consolidation is that the rights to fly from country A to country B are governed by bilateral agreements," Mr Solon says. Should two European carriers merge, they may find they lose some of their rights to fly certain routes (notably across the Atlantic), as they will have only one country's allocated flights rather than two.

This rocky path could be smoothed if the European Commission gets its way. It is suing eight countries, including the UK, with the aim of making them hand over their rights to negotiate. Should the court rule in favour of the commission, European airlines could find it easier to merge, sparking corporate action across the industry.

"What we need to see for long-term financial health is a normalisation of the industry, like in telecoms, where national ownership is irrelevant," says Gerald Khoo, a transport analyst at BNP Paribas.

Other regulatory blocks could be eased. BA has been waiting for approval of an alliance with American Airlines. Now the process could be speeded up. "The US and UK authorities have apparently brought forward the timetable for their discussions concerning the BA and American Airlines alliance plans," says a Schroder Salomon Smith Barney research note. Other engagements waiting in the wings could soon find they are on course for a quick trip to Gretna Green. "Air France, Alitalia, CSA (the Czech national airline) and Delta should also experience a relatively easy acceptance of their alliance proposals," says the research. The alliances of today could be the mergers of the future.

Even before 11 September, governments were planning substantial changes for airlines. Deregulation was intended to create a more competitive environment and one major factor in this was negotiating "open skies" agreements between countries, with no limits put on the amount or price of flights. The US favours this approach, and as European carriers reach out to their American counterparts, the pressure is on to speed the pace of negotiations.

"The atrocity of September 11 will accelerate the process," Mr Solon said. "All airlines urgently need to be part of an alliance with antitrust immunity. The US only gives this to those with open skies."

Consolidation will come too slowly for many airlines in deep financial trouble. The current parlous state of Swissair and Sabena – which were kept afloat only by the injection of large sums of cash by the Swiss and Belgian governments – is a warning for all carriers with weak balance sheets in the current crisis.

Those without the benefits of state aid could find they are in trouble.

Aer Lingus, for example, is under pressure. The Irish national carrier has lost 80 per cent of its passengers to the US, yet its government has said it is unlikely to give it financial support.

It's not just the airlines that are facing hard times. Those who rely on them for business are also likely to be affected. The two main aircraft manufacturers, Boeing and Airbus, are almost certain to experience a reduction in orders, although Boeing's involvement in the manufacture of warplanes could help it keep its pre-eminent position.

"If the US defence budget ratchets up as much as I think it will, Boeing will get a piece of it, while Airbus won't benefit from that in Europe because most of its aircraft are commercial," Mr Solon says.

The future of the aviation industry remains uncertain. "Predict what will happen in five years? I can't predict what will happen in five weeks," says one City analyst. But airlines will have to become leaner and meaner and be willing to swallow their pride and sacrifice their sovereignty if they are to survive.