Lasse Heinonen, CFO of Finnair, is well aware of the €2 billion airline’s competitive advantage: from its hub in Helsinki, Finnair offers a travel time to northeast Asia faster than any other European airline. But like most medium-sized European flag carriers, old obstacles had prevented him from exploiting its asset. In his efforts to encourage passengers bound for northeast Asia to connect via Helsinki, Heinonen ran up against powerful labour unions. They had negotiated a collective agreement limiting the number of long-haul flights that cabin crews could work to just two a month. There was no way Finnair could operate the Europe-Asia route effectively with these terms.

The situation changed after profits slumped from €12.2m in the first quarter of 2005 to a net loss of €3.8m a year later. Heinonen then launched an €80m cost-cutting programme that included 670 job losses. Under such pressure, he was able to renegotiate the agreement to bring the maximum number of long-haul flights for each crew member to five a month. Today the strategy is winning plaudits from both investors and analysts.

“The issue for any medium-sized airline is to know where they have strength and to develop that area of the business — that’s something that Finnair is doing superbly,” says Andrew Lobbenberg, an analyst at ABN Amro in London.

Heinonen isn’t alone in having to chart a new course back to profitability. Squeezed between the bigger, more successful flag carriers at one end and the pan-European budget airlines at the other, rethinking the business strategy has been a priority for every CFO of a medium-sized European flag carrier. Ulrich Schulte-Strathaus, secretary general of the Association of European Airlines (AEA), reckons Europe is seeing a convergence of business models between the full-service and no-frills carriers.

As a result, many are following the lead of budget airlines by stripping away operating costs to allow for discounted ticket prices. Others are focusing on the most profitable parts of their business while selling or outsourcing the rest. All CFOs are having to counter the power of the trade unions, often by turning them into partners rather than adversaries — and persuading interfering government owners to allow management to make sensible commercial decisions. Another challenge is the long rise in oil prices; and while some CFOs have attempted to deal with that through hedging or surcharging, few have managed to avoid taking a hit on profits.

Heinonen is fairly typical of the CFOs coping with these challenges, though more successful than most. While growth in its European and domestic business has been fairly flat, Finnair’s Asia business is now growing at 30% a year. In the first quarter of 2007, Finnair reported an operating profit of €13.7m, far exceeding analysts’ expectations.

Others are not doing so well. The futures of Alitalia, Italy’s flag carrier, and Greece’s Olympic Airlines look uncertain. Gabriele Spazzadeschi, Alitalia’s CFO, quit unexpectedly in April and local press reported rumours that he didn’t want to sign off the 2006 full-year results, which eventually revealed a net loss of €625.6m. Alitalia puts this down to strikes and high fuel costs. Analysts add poor productivity to that list. The Italian government, which owns 49.9%, is currently looking to sell all but 10% of its share.

In Greece, government attempts to sell financially troubled Olympic Airlines are being hampered by a demand from the European Commission that the government recover around €700m in “illegal” state aid. A parliamentary bill protecting the airline from its creditors is due to expire this October, adding to its woes.

The Pressure’s On

Both airlines should have seen these problems coming. Competitive pressure on Europe’s mid-tier flag carriers has steadily increased since 1987, when the European Union launched a phased programme to deregulate its aviation market. But it wasn’t until the mid-1990s, when budget airlines entered the market, that the flag carriers really started to suffer. Encumbered by high costs, inflexible labour unions and interfering government owners, they failed to respond quickly enough to low-cost, low-fare airlines that were cutting ticket prices aggressively. Swissair, the former national airline of Switzerland, was the most high-profile casualty. After taking a 49.5% stake in Sabena, the Belgian flag carrier, a slump in demand following the terrorist attacks of September 11th 2001 triggered a cash-flow crisis. In 2002, Swissair collapsed, taking Sabena with it.

It’s about to get even tougher for the industry. An EU-US agreement to liberalise the transatlantic air travel market, known as “Open Skies,” is due to take effect in March 2008. It will allow European airlines to operate flights to the US from any EU country, as opposed to just from their home country, as is now the case.

“Smaller European airlines — all these little flag carriers flying from a protected home market to the United States — now may have a British Airways or Lufthansa march into their market,” warns Phillip Baggaley, Standard & Poor’s managing director of ratings services.

The deal has prompted much talk of consolidation. KLM and Air France have already entered into a quasi-merger, Lufthansa has clearance to take over Swiss — Swissair’s successor — and BA is part of a private equity consortium bidding for Spain’s Iberia. But one barrier to consolidation is the threat that EU airlines could jeopardise lucrative bilateral agreements with non-EU countries other than the US if they merge or are taken over.

Also, most just aren’t that attractive to potential buyers. “No one wants to buy half-baked second-tier carriers, except possibly some of the private equity houses,” says Keith McMullan, managing director of consultancy Aviation Economics. That said, “it’s probably incorrect to group mid-tier national carriers together just because of size…Some have just not adapted to deregulated markets and have relied on government support, either legally or illegally, while others have been very successful and profitable and found good geographical niches for themselves.”

Find Your Niche

One airline on the latter path is Scandinavia’s SAS. Last month, it announced that it was pulling back from its pan-European ambitions to focus purely on northern Europe. The SKr60.8 billion (€6.5 billion) airline, still 50% owned by the governments of Sweden, Denmark and Norway, has struggled to get back to profitability following the downturn in air travel after 2001 and Asia’s bird flu outbreak a year later. A SKr2.8 billion profit in 2000 turned into a pre-tax loss of SKr1.1 billion in 2001. Last year, the carrier reported a pre-tax profit of SKr929m.

A new four-year growth plan sets tough targets to increase annual pre-tax profits to SKr4 billion while reducing costs by SKr2.8 billion. It plans to do that by selling stakes in Spanair, Air Greenland and BMI of the UK. The carrier will also re-evaluate the rationale for keeping support operations such as SAS Ground Services and SAS Technical Services in house, according to CFO Gunilla Berg.

The only thing preventing SAS from completely dominating the north European market is Finnair. Lars Heindorff, a Copenhagen-based analyst for ABG Sundal Collier, points out SAS-Finnair is an obvious merger that has been talked about for many years but the Finnish government — which owns a 57% stake in the carrier — is unlikely to sanction it.

Heinonen says SAS’s cumbersome industrial relations would be a major barrier. “[SAS] is a company with 39 labour unions so it’s not a very easy concept to merge with. Labour unions are very strong in this industry; very often in mergers that can become rather difficult. So we are now focusing on our organic growth and restructuring ourselves and having the Oneworld Alliance [a marketing agreement with other airlines], and other partners complementing our services.”

SAS knows it must tame the unions to achieve growth. The airline has dealt with 100 strikes in the past decade — two, in the second quarter of this year, cost the company SKr200m. The new strategy seeks to quash industrial unrest by involving employees in a share ownership scheme and offering unions a “new model of co-operation.” CFO Berg knows the strike culture must change and that without a focus on market opportunities, SAS will find it difficult to stay profitable and independent.

Hybrid Models

Greg O’Sullivan, the CFO of €1.1 billion Irish flag carrier Aer Lingus, knows all about the difficulty of maintaining independence. O’Sullivan and the rest of the Dublin-based management team have been facing intense takeover pressure from Irish budget airline Ryanair. Many industry commentators point to Aer Lingus as the best example of a successful middleweight European airline, although that hasn’t always been the case. From near bankruptcy after September 11th, the carrier has gone through what one corporate financier describes as “one of the best restructuring stories in the airline industry.” Its hybrid model — comprising a low-cost, low-fares short-haul business and a long-haul business servicing Ireland-US routes — is unique in the industry.

“Demand for air travel at low fares continues to increase,” says O’Sullivan. “We met that challenge by reducing costs, expanding our short-haul network, focusing on point-to-point services, reducing fares and — as our advertising strapline states — providing a product that is ‘way better’ than the other low fares carriers.”

“Way better” means passengers fly to more centrally located airports, have a pre-assigned seat, can use the airline’s automated check-in kiosks to avoid long queues and are looked after in times of disruption. “The evidence is that people appreciate some of the value for money that we provide,” says O’Sullivan, adding that in the first five months of 2007, short-haul passenger traffic increased 6% on the year. But the recent introduction of small fees for booking online with a credit card, checking in bags and reserving popular seats, may dilute that appreciation.

Aer Lingus’s turnaround led to a successful IPO on the London and Dublin stockmarkets last autumn, which raised around Û500m to grow the business. Much of that growth is expected to come from the long-haul division, where it has just announced plans to double its fleet to 14 by 2014. The extra aircraft will allow Aer Lingus to exploit its close ties with the US by opening up new routes to additional American cities under the Open Skies deal.

“Aer Lingus is in a unique position,” says O’Sullivan. “We have great brand recognition in the US but our ability to grow has been constrained up to now because of regulatory restrictions.”

O’Sullivan has already struck an interim deal with the US to fly three new routes — to Washington, DC, Orlando and San Francisco — from September, six months before Open Skies takes effect. Analysts think these routes alone could boost the carrier’s revenues by more than €200m a year. To add to this headstart, Aer Lingus recently linked up with the web-based booking system of US low cost carrier JetBlue, allowing passengers to get flights through Ireland to any of JetBlue’s 51 destinations in the US and Caribbean, and vice versa. But its trump card is that Ireland is the only EU country to have pre-clearance for US customs and immigration — a powerful selling point for stress-free entry into the US.

All this strengthens Aer Lingus’s hand as it fends off a bid from Ryanair, which bought 25% of the company to block other potential buyers. EU competition authorities blocked Ryanair’s bid last month on the grounds that it would harm competition and undermine consumers, but the budget carrier plans to appeal.

Get Eaten

Regional consolidation is in full swing to the east, led by the Russians. In April, Hungary’s government sold a 99.95% stake in flag carrier Malev to Russia’s fourth largest airline, KrasAir, for €800,000, with an additional agreement to repay Malev’s €130m debt and put in €50m of development capital. To meet EU rules, the sale was made to AirBridge, a Hungarian company affiliated to AiRUnion, an alliance of five Russian airlines including KrasAir, its biggest member. Russia’s government holds a 51% stake in KrasAir.

Gaining a foothold in Europe outweighed any worries about the debt load for KrasAir, which has ambitions to be the second largest player in Russia after Aeroflot. “Malev will preserve its route network with around 50 European cities and gain access to 54 destinations in Russia and the CIS,” KrasAir’s CEO, Boris Abramovich, told reporters before winning the deal. “Teaming up will allow both of us to boost traffic and profits before long.” Abramovich plans to make Malev, which posted a net loss of €4.6m in 2006, profitable in the next two years and triple passenger numbers and sales by 2015.

KrasAir rival Aeroflot, Russia’s biggest carrier, is hot on its heels in the region: it has been linked to Serbian flag carrier Jat Airways, although no formal offer has been made. “We would be interested in purchasing a stake in this airline if there is a firm decision to privatise it; but the deal has to be sensible — purchasing foreign airlines at any cost is not our goal,” says Mikhail Poluboyarinov, Aeroflot’s CFO. “But in general, Jat is interesting for us since it can be instrumental in the potential formation of a pan-Balkan hub.”

Alitalia was almost within Aeorflot’s reach but pulled out of a bidding fight last month after it was unable to meet the sale terms. Poluboyarinov admits turning around Alitalia would have been tough but Aeroflot wanted access not only to the affluent Italian market, but also to Alitalia’s lucrative routes to southern Europe, North Africa and Latin America. Poluboyarinov says having turned Aeroflot around through a programme of cost-cutting, fleet renovation and strong people management, more than doubling its market capitalisation to €1.8 billion, the management team was well placed to do the same at Alitalia. Aeroflot’s reform proposals included dropping money-losing destinations and replacing Alitalia’s ailing fleet of MD80s with 20 Sukhoi SuperJet-100s — a more fuel-efficient Russian jet with lower operating costs.

Aeroflot may have lost out to rival AP Holding, owner of Italian carrier Air One, but there are other potential targets: it has been linked to Austrian Airlines and the Czech and Polish governments want to privatise their flag carriers — Czech Airlines and LOT.

Despite all this activity, KrasAir’s purchase of Malev and Lufthansa’s takeover of Swiss are the only completed transactions among the middleweight flag carriers. (View pdf here.) AEA’s Schulte-Strathaus reckons constraints on ownership and control mean struggling airlines will first look for innovative ways of closer co-operation through alliances or partial mergers. Rising above the fray will be carriers that, like Finnair and Aer Lingus, identify their profitable niches and ruthlessly unload excess baggage.