Lufthansa' purchase of Swiss may be another step in the inevitable march toward industry consolidation, but merger and acquisition activity is unlikely to hit its stride until more of the regulatory roadblocks are removed

Lufthansa's acquisition of Swiss has again sent a ripple of anticipation around the European industry and beyond. Following last year's Air France/KLM merger, investment bankers are no doubt already engaging in earnest conversations with other chief executives about the need to follow suit or risk being left behind. With Brussels and Washington also gearing up to try again for transatlantic open skies could a new round of industry consolidation be in the making? Maybe, but history teaches that in the world of airline mergers fortune tends to favour the cautious.

Despite some of the grander talk about Lufthansa's ambition to build its presence in Switzerland – a "stronghold in Europe" in the words of its chief financial officer – the Swiss deal looks suspiciously defensive. With nowhere else to go, Swiss was on life support and its shareholders cannot have relished the prospect of another expensive resuscitation. Lufthansa, for its part, had every reason to want to avoid a competitor arriving in Zurich, dangerously close to its Munich hub. Zurich will be kept intact but developed "in co-ordination" with Frankfurt and Munich.

The usual case has been made for potential synergies, but the numbers are relatively modest. By 2008 the aim is to make annual gains of €165 million ($205 million), of which half come from the somewhat grey area of revenue benefits. Put in context, that represents less than 1% of the combined group revenues of upward of €19 billion.

But the price paid for capturing Swiss has been modest too. As the details unfolded, it became clear that Lufthansa would pay only €45 million to stock-market investors and that the Swiss carrier's other state and corporate backers, who must already have written off their holdings, will only earn payment if Lufthansa's stock price outperforms that of a basket of its airline peers – they should not expect too much.

Nevertheless, it is clear that both Air France and Lufthansa are beginning to build imposing power blocks in Europe. Lufthansa has spread its influence across Germany's neighbours from Austria, through Poland, round to Scandinavia. Air France has tied up the Netherlands and potentially Italy, if Alitalia revives. On current standings and with mergers complete, both groups will be turning annual revenues of around $24 billion, putting them comfortably atop the world league. British Airways continues to hover around $15 billion. So should it, and others, worry? Not necessarily.

The virtue of merger and acquisition activity comes from the value that it delivers under three broad headings: growth – gaining access to new markets or assets; cost – economies of scale and synergies; and defence – closing out an existing or likely competitor

Gaining access to a growth market such as Asia-Pacific would indeed be an unmissable opportunity for a European or US carrier, but it is not an option until skies open and ownership restrictions fall. By contrast, in mature home regions where acquisitions are possible they are also less certain to guarantee growth. While Swiss may bring its existing customer with it, there are no guarantees that they will stay loyal. As the low-cost carriers demonstrate if you have the right fares and the right service it is possible to grow like topsy in direct competition with long established brands.

With its latest order, Ryanair aims to be flying a fleet of over 300 aircraft carrying 70 million passengers within the next decade. On present standings that would make it the largest carrier within the intra-European market and easyJet plans not to be too far behind. To compete, the major carriers do not need to buy market share but to cut costs. That, in reality, is what Lufthansa's main game is likely to be as it addresses efficiency and its own low-cost strategy.

The US experience illustrates the vulnerability of established majors in the new conditions. Despite owning the bulk of the market, the big six US majors have demonstrably lost all pricing power, which it is now been driven by smaller low-cost competitors.

Mergers could theoretically help improve costs. But for airline majors already struggling to cut their own costs, and hampered by political sensitivities, achieving post-merger synergies is a slow and potentially hazardous task.

It is hard to argue that consolidation is not overdue in the airline sector pretty much worldwide, but what is still needed to spark a real frenzy of acquisitions, mergers and failures is a change in the regulatory environment. Until then, defensive rather than offensive moves may be the more common play.

Source: Airline Business