Global Policy Forum

By John Tagliabue

Europe's skies are changing, and KLM Royal Dutch Airlines and Air France intend to stay ahead of the changes. They will create the largest European airline through the first major cross-border airline merger in decades, their chief executives said on Tuesday. The catalyst for the deal, they suggested, was a fundamental change in how air transport agreements were negotiated. The European Court of Justice ruled last November that the European Union had the power to override its 15 member nations' individual deals with nonmembers and negotiate open-skies agreements that cover them all.

Talks on a new Europe-wide agreement with the United States are to begin on Wednesday. And when 10 more countries join the union next year, the common air-travel market will widen further. "It's time for the airline industry to accept this European dimension," said Jean-Cyril Spinetta, chief executive of Air France, who first suggested the merger to his counterpart at KLM, Leo van Wijk, 21 months ago. Indicating that the day of national champion "flag carriers" was ending, Mr. van Wijk added, "All airlines know that the structure of our industry cannot be maintained." Borrowing from the consumer goods industry, Mr. Spinetta and Mr. van Wijk said at a joint news conference that their two airlines would form a holding company to be called Air France-KLM, but remain independently managed and preserve their distinct identities. The company would have three core businesses, they said — passengers, freight and aircraft maintenance.

If the merger is approved by regulators in Europe and the United States, Mr. Spinetta would become chief executive of the combined company and remain head of the Air France subsidiary; Mr. van Wijk would be his deputy at the holding company and remain head of KLM. For Air France, the deal crowns a seven-year comeback from near-bankruptcy in the mid-1990's. For KLM, which has been struggling to reverse losses by imposing job cuts, a merger represents a quick injection of capital and a strong partner.

For air travelers, little change is expected, at least right away. KLM will join the SkyTeam marketing alliance led by Air France and Delta, and its American partner, Northwest Airlines, will probably do so as well. Schiphol Airport in the Netherlands will remain KLM's hub, and Charles de Gaulle Airport near Paris will remain Air France's. Over the long term, the merger will probably speed the transformation of the European airline industry into something more like that in the United States, with fewer, larger carriers competing on more routes and restraining fares.

Some executives and analysts said that deals like the one on Tuesday, with its focus on long-haul routes, would spur the growth on short-haul flights of newer discount carriers, like Ryanair and EasyJet, adding further pressure to hold down Europe's traditionally high air fares. But others said Tuesday's deal seemed mostly aimed at market dominance. "Ultimately, it is an attempt to control the degree of competition in the market," said Keith McMullan, joint managing director of Aviation Economics, a London airline consulting firm. Likewise, Ryanair issued a statement saying that big airline combinations like that of Air France and KLM were "essentially anticompetitive" and would probably lead to reduced capacity and higher prices.

Under the deal, Mr. Spinetta said, Air France shareholders would receive one share in the new holding company for each Air France share; they will own about 81 percent of the company. KLM shareholders will receive 11 new shares for every 10 KLM shares, plus warrants for additional shares that are good until early 2008. The deal values KLM at 16.74 euros a share, or 784 million euros ($913 million), a 40 percent premium over KLM's closing price on Monday. Not surprisingly, shares in KLM rose more than 12 percent in Amsterdam on Tuesday, while Air France shares fell 4 percent in Paris.

Philip Butterworth-Hayes, editor of Jane's Airport Review, noted that airlines from Denmark, Sweden and Norway successfully combined after World War II to form SAS, and said that the merger announced on Tuesday would be groundbreaking for the industry as well and "could lead to major changes."

Europe these days is scattered with small national airlines, many of them losing money or only marginally profitable, like Iberia of Spain, Olympic Airways of Greece, Aer Lingus of Ireland and TAP of Portugal, and their future is uncertain. In the 1990's, Swissair tried to stitch together a Europe-wide network by buying stakes in such carriers, but it was blocked from taking majority control and ultimately collapsed under the weight of their losses, especially those of the Belgian carrier Sabena. A reconfigured carrier, Swiss International Airlines, has assumed some of Swissair's old role. The Air France-KLM deal was a setback for Alitalia, a longtime money loser, which owns 2 percent of Air France and had been pressing to be included. Mr. Spinetta — who held joint news conferences on Tuesday with Mr. van Wijk at both Schiphol and Charles de Gaulle Airports today — said that Air France and KLM had signed new cooperation agreements with Alitalia that would, among other things, combine all three airlines' cargo businesses. Alitalia said it hoped to join the merger before long, but Mr. Spinetta would not say whether or when that might happen.

Even so, a chart of the new company's network, displayed at the news conferences, showed Milan as a hub along with Schiphol and de Gaulle, illustrating the challenge that the merger poses to British Airways, which the new company would eclipse in size, and to Lufthansa, the next largest in Europe. Mr. Spinetta said the new network was meant to match that of British Airways, which is building a hub network around London's Heathrow, Madrid (home of Iberia, one of its closer partners), and Zurich (home of Swiss International, which announced an alliance with British Airways last week). Similarly, Lufthansa has built a hub network around Frankfurt, Munich, Copenhagen and Vienna.

Already, Mr. Spinetta said, some 54 percent of all European long-distance air traffic is concentrated at the four busiest airports — Heathrow, Frankfurt, Paris and Schiphol — and that trend is expected to continue. Air France-KLM would be the world's largest carrier by revenue, with a combined 19.2 billion euros ($22.4 billion) and a combined 58.8 million passengers a year. Measured by passenger-miles, it would rank third worldwide after American Airlines and United Airlines.

The merger would effectively end KLM's 84-year history as an independent airline. The new shares issued to buy it would dilute the French government's stake to 44 percent, from 54 percent of Air France now — a concession to Dutch sensibilities. To protect KLM's landing rights under existing agreements, a majority of the voting rights, though not the equity, in the KLM subsidiary would be held for three years by the Dutch government and two Dutch foundations, keeping it technically Dutch. Some analysts saw the seeds of future governance problems in the arrangement, but Mr. van Wijk said that there was no risk and that KLM's management had "always been driven by economic interests."

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