IAG's Acquisition of BMI

In December 2011, International Airlines Group SA (IAG), the owner of British Airways and Iberia, agreed to buy UK airline British Midland International (BMI) from its owner, Lufthansa. The deal was completed on 20 April 2012.

Before its sale by Lufthansa, BMI had incurred large losses. AIG now plans to break it up and absorb its remnants into British Airways. This will mean the end of an airline with a history of many decades of operation.

BMI operated a fleet of sixty aircraft, including Airbus, Boeing 737s and Embraers. It carried 5.7 million passengers in 2011. It was made up of three separate airline units, all focusing on different segments of the UK travel market.

British Midland International was a medium-haul airline unit with a hub at Heathrow that flew to destinations in the UK, Europe, the CIS, the Middle East and Africa. BMI Regional was a short-haul airline unit operating Embraer aircraft from seven regional airports in England to destinations in the UK and Europe. bmibaby was a low-cost airline unit with a fleet of fourteen Boeing 737s operating flights within the UK from hubs in central England.

The purchase agreement provided for a price of £172.5 million. But the price was to be reduced for BMI restructuring or closure costs that AIG incurred after buying BMI. Also included in the sale were BMIís 56 daily slot pairs at Heathrow. Lufthansa retained BMIís defined benefit pension scheme, which had a large deficit.

The reason that IAG gave for buying BMI was to enable IAG to grow at Heathrow. It undertook to make more efficient use of BMIís Heathrow slots, which it said would give it the option to launch new longhaul routes to key trading nations. Its plans to expand its longhaul network would, it said, guarantee growth. BMIís operating losses, however, would force it to restructure BMIís business, with the result that jobs would be lost.

Lufthansa at BMI

Lufthansa acquired its first interest in BMI in 1999 when it bought 20 percent of the airline. It bought the remaining 80 percent in 2009 for £223 million, at a time when BMI was already making losses.

With full control of BMI, Lufthansa tried restructuring the airline to make it profitable. It tried to cut costs by reducing the scope of BMIís operations. A BMI base at Glasgow was shut down, and the number of BMI flights to Berlin-Tegel that competed with Lufthansa flights were reduced. bmibaby withdrew from Manchester and Cardiff.

But while it cut costs at BMI, Lufthansa simultaneously tried to boost BMIís revenues by expanding its route network. New routes were established to Casablanca, Marrakesh, Agadir, Bergen, Stavanger, Nice and Amritsar. BMIís labour costs were increased rather than cut, with employee numbers rising from 3,600 in 2010 to 3,700 in 2011.

Lufthansa claimed that cost-cutting measures at BMI were effective, but it conceded that they had failed to offset higher fuel costs and increased fees and charges. BMI was unable to meet revenue targets set by Lufthansa. Lufthansa noted that economic conditions in the UK were uncertain, and there was strong competition from low-cost carriers in BMIís UK home market, which impacted its profitability. BMIís routes to the Middle East and North Africa were disrupted by unrest in those areas, and many of its flights had to be cancelled.

Having failed to restore profitability at BMI by 2011, Lufthansa started explore a sale or breakup of the airline, and eventually decided to sell. It took the sale decision because it predicted a difficult future for BMI, on account of the structure of the UK air travel market, and capacity limitations at Heathrow, which were the reasons why Lufthansa had been unable to realise the full strategic value of BMIís slots at Heathrow.

Valuing BMI

The decision to sell BMI meant that it had to be valued. In 2010 BMI had reported gross assets of £284 million, consisting mainly of its Heathrow slots and the BMI brand. It had few tangible assets and all of its aircraft were leased.

An investment bank suggested that BMIís net asset value was £400 million, after the deduction of restructuring costs and BMIís pension deficit, and the addition of synergy benefits that a buyer would receive. But this valuation proved to be far off the mark.

Despite the claimed value of its assets, BMI had big operating losses. Its 2011 revenue of €911 million was exceeded by expenses of €1,092 million, resulting in an operating loss of €181 million. Lufthansa financed this loss by contributing equity capital of €301 million to BMI.

A selling price for BMI was eventually agreed at £172.5 million, but with reductions for restructuring costs incurred by the buyer. These reductions resulted in the purchase price going negative by €130 million, implying that Lufthansa paid this amount to IAG to take BMI over.

The competition for Heathrow slots

One of the main factors in the sale of BMI was its takeoff and landing slot pairs at Heathrow. Heathrow has a severe slots shortage because it is operating at full capacity and the UK government has rejected expansion by the construction of a third runway.

Meanwhile, like all businesses airlines want to grow. They can grow organically by increasing the number of aircraft in service, and expanding route networks. But organic growth is slow and airline managements often want faster growth by other methods. One way to boost growth is by acquiring slots at hub airports where the number of slots is limited.

BMIís most valuable asset turned out to be its allocation of 11 percent of the slot pairs at Heathrow. It held the second largest slot portfolio after IAG, which had 45 percent of Heathrow slots. Virgin Atlantic was third with 3 percent.

Both British Airlines and Virgin Atlantic use Heathrow as a hub and need slots at Heathrow in order to grow. The only way for them to obtain slots is to buy or rent them from other airlines, or take over airlines that have slot allocations.

Virginís bid

Virgin Atlantic, which is privately owned by Sir Richard Branson and Singapore Airlines, had been keen on a merger with BMI for many years. But past attempts to merge with BMI had failed, because Virgin and BMIís former owners could not agree on terms.

When the news broke in 2011 that BMI was for sale, Virgin immediately came forward with an attempt to buy the airline. It held talks with Lufthansa, which allowed it to do due diligence on BMI. Lufthansa and Virgin even agreed a term sheet for a deal.

But Virgin lacked finance for a bid. So it tried to form a consortium with Etihad, the Abu Dhabi airline, hoping to make a joint bid for BMI. Etihad was interested in a bid for BMI because it wanted to link its longhaul routes from the Middle East to BMIís medium and short-haul network in the UK and Western Europe.

Virgin made a bid of £50 million for BMI. Its bid was much lower than IAGís bid of £127.5 million, because it assumed that IAGís bid would involve costly regulatory hurdles that a deal with Virgin would avoid. But this assumption turned out to be incorrect.

Virgin later withdrew its bid, and chose instead to try to prevent the IAG deal on competition grounds.

The competition issue

While making its bid to buy BMI, Virgin tried to obstruct IAGís competing bid. Virgin urged EU competition authorities to block the IAG-Lufthansa deal, claiming that it would have harmful competition effects. Virgin pointed out that British Airlines was already the dominant airline at Heathrow and that if IAG was allowed to buy BMI, BAís Heathrow dominance would be strengthened, enabling it to charge excessive fares. Virgin also argued that the IAG deal would harm consumer choice.

The UK competition authority, the Office of Fair Trading, declined to take sides. It said that UK approval was not required for the IAG deal, and that approval by the European Commission would suffice. The OFTís reason for standing back was that the competition effect of the IAG deal on Heathrow required a review of routes across many countries, and that the European Commission had more expertise in evaluating airline mergers.

In an attempt to ensure approval of its purchase of BMI, IAG offered concessions to the EU competition authorities. The full nature of these concessions were not made public, but the European Commission usually demands that the buyer of an airline must either cede slots to rival airlines or offer them participation in its frequent flyer program.

What is known is that IAG undertook to relinquish 14 of BMIís slot pairs. The European Commission split the 14 slot pairs into three groups Ė two slots were leased by IAG to a Russian airline, and of the other twelve, seven were to be used for flights between Heathrow and Scotland, and five were to remain available for use on a restricted basis. The 12 remaining slot pairs are due to be auctioned.

By April 2012 Virgin was reported to be planning to launch its first UK domestic flights. It had wanted to obtain some of the BMI slots for this project, because the slots would enable it to connect its UK domestic passengers with its overseas longhaul network. Virgin welcomed the European Commissionís decision to order the auctioning of the twelve BMI slot pairs.

After its antitrust complaint was rejected, Virgin decided to appeal the European Commissionís decision to allow the IAG deal. It relied once more on the ground that the deal would lead to a reduction of competition at Heathrow, and that this would result in more costly air travel. Its appeal remains unresolved.

After taking control of BMI in May 2012, IAG announced the cutting of 1,200 BMI jobs. But 1,500 BMI jobs were to be retained, including 1,100 jobs for pilots, cabin crew and engineers at Heathrow. All of BMIís jobs at its former headquarters at Derby and at its bases at other UK airports were to be cut.

Originally pubished in Airline Economics May - June 2012.