British Airways-Iberia Merger Talks On The Rocks

January 29, 2009

"At the moment it doesn't look very likely to go ahead. A one-to-one share ratio would be too much for BA shareholders to stomach," -- Exane BNP Paribas analyst Nick van den Brul.

British Airways and Spanish partner Iberia may walk away from merger talks, or seriously delay a deal, because of ever-widening disagreements over what the two carriers are worth.

British Airways had expected to call the shots when the long-term partners announced merger plans last July, but since then its tumbling share price, a ballooning pension deficit and a profit warning this week have put Iberia in the driving seat.

BA stock has lost nearly 45 percent since the pair unveiled the exclusive merger talks, while Iberia has risen about 11 percent. Add in the British pound's drop against the euro and Iberia has emerged the larger in terms of market capitalization -- EUR1.75 billion euros (USD$2.32 billion) against BA's GBP1.57 billion pounds (USD$2.24 billion).

That is a radical turnaround for the Heathrow-based airline, which expected to take around 65 percent of the new airline.

BA CEO Willie Walsh told newspapers last week that BA shareholders would not accept the current market cap-based split and Exane BNP Paribas analyst Nick van den Brul said even a 50-50 division is likely to be a deal-breaker for BA, which outscores Iberia on other measures.

"At the moment it doesn't look very likely to go ahead. A one-to-one share ratio would be too much for BA shareholders to stomach," said van den Brul, who does not expect any deal for another year until BA's share price rebounds.

According to BNP Paribas estimates, BA has an enterprise value of GBP6.1 billion versus Iberia's GBP3.6 billion, mainly thanks to owning a greater proportion of its 245 aircraft than Iberia does of its 198-strong fleet.

Analysts are also forecasting BA will rake in GBP9 billion (EUR9.64 billion) of revenue in the year to March according to ThomsonReuters estimates, versus EUR5.45 billion estimated by Iberia at an analyst presentation on Wednesday.


Just as BA shareholders are likely to be backing away from a merger while its shares are in the doldrums, so Iberia is moving more cautiously because of BA's pensions liabilities.

Iberia Chairman Fernando Conte confirmed to analysts on Wednesday that talks were focused on valuations -- including the impact of BA's pension gap -- but he also struck a positive note by stressing "substantial revenue and cost synergies".

The Madrid-based carrier has hired independent pension experts Mercer to study the health of BA's retiree scheme -- a report to be delivered within weeks -- ahead of a full actuarial valuation from BA pension trustees due out in late summer.

Both are almost guaranteed to calculate a far bigger deficit than the GBP1.5 billion hole in its main scheme identified by trustees as of March 31 last year.

"Not only will pension assets have fallen since March as markets have dropped, but the higher corporate bond yields in recent months mean that many companies pension liabilities appear smaller in their accounts than might be the case in reality," said Jerome Melcer, a partner at pensions consultants Lane Clark & Peacock.

Andy Scott, principal of pensions consultant Punter Southall, said falling interest rates also would have sapped asset growth which would not have been compensated by falling inflation.

"Falling markets and a reduction in interest rates is highly likely to have had a greater effect," he said.

BA's total pension liabilities -- GBP13.55 billion in March 2008 -- are of such a scale that relatively small changes in actuarial assumptions, such as another year on assumed life expectancy, could increase liabilities by hundreds of millions of pounds.

Until the size of the deficit is known -- and Mercer is happy that trustees have no exceptional powers to demand cash from the business -- Iberia will sit tight, experts say.

"I don't see anything happening before the pension deficit is known," said van den Brul. "Directors would wish to know the maximum extent of the liabilities before proceeding".

BA Chairman Martin Broughton said in September that a merger should be finalized by March this year, but in recent comments CEO Walsh has notably declined to give a timescale.


BA's profit warning has not made the prospects for a successful merger any better. It said the weakening economy and plummeting pound would see it drop into the red for the full year -- with little sign of a positive upside.

Meanwhile although Iberia said on Wednesday that estimated 2008 net profit fell 90 percent, it would remain in the black and had initiatives planned for 2009-2011 to add EUR450 million to core earnings.

However Douglas McNeill, transport analyst at broker Blue Oar, said there was time for events to swing back in BA's favor.

"Market caps are an important element of the mix, and are not developing in a way that smoothes the path to a merger. But Iberia has indicated the timing of an eventual deal would be some months away yet, and BA is likely to have a better year next year than this."

The market appears to believe the merger is in trouble.

Significantly BA's profit warning last week pulled Iberia's stock down as the market discounted the chance of BA investors backing a merger while BA shares continued to sink.

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