Commission clips wings of troubled state airlines

Date: 15/02/1996

By Tim Jones

ALITALIA has learnt a harsh lesson from the European Commission's decision to allow the bail-out of Spain's flag carrier as it teetered on the verge of bankruptcy.

While Transport Commissioner Neil Kinnock's approval of the 545-million-ecu capital injection may have seemed dangerously weak in London, it was viewed rather differently in Rome.

Facing a crippling strike by its unions in favour of a 740-million-ecu capital infusion, the ailing Italian carrier is making strenuous efforts to avoid going cap in hand to the government for a subsidy - knowing any such payment would have to be approved by the Commission.

Rather than risk having to bow to the kind of conditions Kinnock imposed on Iberia, Alitalia's management has been in talks with banks this week in a desparate attempt to arrange a private-sector recapitalisation.

“If we have to go to Brussels, they will force us to cut capacity, limit our aggressive pricing strategy and make us sell assets,” warns Alitalia Commercial Director Hans Udo Wenzel. “We absolutely want to avoid that.”

But while Kinnock's tortuous vetting of the Iberia aid sent shivers through the boardrooms of Air France and Olympic Airways (both companies need clearance of new aid instalments in the coming months), as well as Alitalia, UK Prime Minister John Major condemned the decision as contrary to the interests of passengers.

Kinnock's problem was that he inherited a contradiction when he took office at the beginning of 1995. Only 30 months earlier, Iberia had been allowed a subsidy of 750 million ecu, but on the strict condition that it would apply for no further aid before its restructuring plan expired at the end of 1996. At the same time, Kinnock was bound to consider a new application for aid as if Iberia's holding company were a long-term strategic investor.

While parts of the airline's cost-cutting plan went well, the second prong of the programme - a strategic shift towards Latin America - went horribly awry.

An ambitious 875-million-ecu acquisition programme, which centred on the purchase of an 85&percent; stake in Aerolineas Argentinas, became a millstone around Iberia's neck. As recession started to bite and the peseta spiralled downwards, Iberia's losses swelled to 440 million ecu in 1993. The 1992 capital injection was wiped out.

Faced with the possibility of liquidation, the government's holding company Teneo agreed to come forward with more equity capital, but only if further radical cost-cutting measures were taken. Wages would be cut by more than 8&percent; and an extra 3,500 jobs lost on top of the 7,000 already shed, in return for 860 million ecu in new capital.

Kinnock had to decide whether a holding company with a strategic interest in the airline business would really shut down Iberia, with its established brand name and lucrative tourist routes.

Using the guidelines, the Commission had to think like a “private company pursuing a structural policy and guided by profitability perspectives in the longer term”.

This meant the Commission could take a hard-nosed commercial approach to allowing recapitalisation, but could not force a company into the private sector.

As a result, when consultants Deloitte Touche reported back on their analysis of Iberia's books, the Commission took a tough line, pointing out that no private investor would consider ploughing 860 million ecu of its hard-earned cash into Iberia while it clung on to its Latin American holdings. If the Spanish authorities insisted on keeping them, Iberia would only be allowed a state aid of 230 million ecu and this would be paid directly to redundant workers, rather than be used for the recapitalisation of the firm.

Offered less than half the sum it had requested, the Spanish government opted to sell the assets and base the additional capital injection on commercial grounds. Like any normal investor, Teneo would invest new money on the careful prediction of future cash flow, assessed in terms of profits ploughed back into the business.

Contrary to popular belief, shedding the stakes in Aerolineas Argentinas, Austral and Ladeco - central to Iberia's rethink and representing 23&percent; of turnover - has proved no easy task and provoked serious division within Teneo and the government.

To give Iberia the possibility of winning back the assets and because an instant sale to another airline was not feasible, US banks Merrill Lynch and Bankers Trust agreed to take a stake in a vehicle company which would buy the Latin American assets. The Commission insisted the banks were the majority shareholders and Iberia was shocked when it was offered 300 million ecu less than expected.

While Iberia will have the right to buy the businesses back within two years, it will have to do it with internal cash flow and only if set performance targets are met.

Above all - and here the Commission is treading a fine line in forcing a company into the private sector - the repurchase would require the “significant” involvement of a private partner.

“This was a clever piece of footwork,” said a London-based airline analyst. “This condition simply reflects realities since, without another investor, Iberia would not be able to buy back these assets from its own funds. But it is dressed up as driving them into private hands.”

The next time a state-owned airline seeks a subsidy, the Commission should be able to sneak in the same kind of condition - and that is exactly what has deterred Alitalia from treading the state aid path.

The tough negotiations between the Commission and the Spanish authorities - including six bruising encounters between Kinnock and Spanish Industry Minister Juan Manuel Eguiagaray - over how much capital Teneo should inject into the slimmed-down company also provided an object lesson in the Commission's new thinking.

It insisted that Teneo set a 30&percent; 'hurdle rate', so assuming a loss of almost one-third of its investment, and reduced Iberia's expectations of future cash flow from 5&percent; annual growth to 4&percent;. This resulted in the 860-million-ecu recapitalisation sought by the airline being reduced by the Commission to just 545 million ecu.

Even this was not cast-iron enough for Kinnock. Once the deal was done, the Commission demanded safeguards to ensure the 545 million ecu was used only to pay off redundant workers and reduce debt. A further 125-million-ecu injection will only be paid in 1997 if these conditions and the company's performance targets are met.

While many private airlines are still unhappy at the decision, some of the big players realise the Commission made the best of the hand it was dealt.

More than that, the conditions won by the Commission will definitely hurt and are much tougher than anything imposed on Air France and Olympic Airways when they were awarded larger aids in 1994.

Kinnock is clearly intent on using the limited powers he has to the full, a daunting prospect for those airlines who are years behind SAS, Lufthansa and British Airways in accepting the disciplines of the market place. “The Commission's job in this sector is to bring all airlines, state-owned and otherwise, into the real world. The days of state aid decisions not linked to commercial criteria are very much numbered,” said one senior Commission official.

If governments want the Commission's powers to be even stronger, actually allowing it to force a state-owned company into private hands, they will have to raise the issue at this year's Intergovernmental Conference.

Until or unless that happens, the Commission will have to continue applying the 'market investor' principle in its capital injection decisions, and the idea of 'one time, last time' aid will remain a mirage.