Is a Cheaper Plane Ticket to Europe in Your Future?

For travelers looking to book a flight to Europe next year, chances are a cheaper plane ticket could be in the cards. And perhaps more flight options, too.

In an unprecedented move in March, the United States and member nations of the European Union backed the first phase of an open skies accord. This is big news for the airline industry and represents the first step in the gradual, yet inevitable, liberalization of air passenger services across the Atlantic.

The European Commission predicts that within the first five years after its ratification, the landmark pact will lower ticket prices, increase trans-Atlantic travel by more than 25 million passengers (a 50% jump), create as many as 80,000 jobs, and provide consumer benefits north of $16 billion. Unless blocked by Congress, we expect the first phase of the deal to be formally signed at the EU-U.S. summit on April 30 and take effect in March 2008, concurrent with the opening of London Heathrow Airport's fifth terminal.

More Capacity, More Competition...and Lower Fares
But how does the deal impact the airline business as we know it? Well, the revenue opportunities for airlines will undoubtedly increase, since the agreement will allow U.S. and European operators to carry passengers between any U.S. and European cities. We expect carriers on both sides of the Atlantic to offer hundreds of additional flights, as more than 20 restrictive bilateral agreements between the U.S. and individual EU nations will no longer be valid.

While this may sound good, profit margins on intra-EU routes and trans-Atlantic routes will inevitably decline, in our opinion. Under the deal, airlines will soon be able to fly to cities in the U.S. from major foreign hubs outside of their home country. That means European carriers could soon find new foreign competition setting up shop in their own back yards. As for airlines that depend heavily on trans-Atlantic routes for profits--like  British Airways (BAB),  Delta , and  Continental --their international performance will also face pressure as the industry eventually reallocates capacity to the most-profitable routes across the Atlantic.

And while aircraft delivery schedules at  Boeing (BA) and Airbus could hinder a massive influx of trans-Atlantic capacity in the near term, the optimization of take-off and landing slots at key airports and the redeployment of aircraft already in service could be enough to jump-start competition and send trans-Atlantic yields (ticket prices) lower as early as mid-2008. Over the longer term, we expect the advent of trans-Atlantic liberalization to inevitably lead to more airplane orders as operators pursue incremental point-to-point flying opportunities between new nonstop city pairs linking the U.S. and the EU. As operators eventually take delivery of these additional aircraft, a permanent reduction in trans-Atlantic airfares should inevitably follow.

Competitive Responses and Potential Consolidation
Just a couple of weeks after all 27 member nations unanimously approved the initial phase of the agreement, competitive responses from several airlines have surfaced. U.K.-based Virgin Atlantic, for example, plans to launch operations to New York from a number of major foreign hubs, including Paris and Frankfurt, while Aer Lingus is preparing to add more destinations to the U.S. from the carrier's base in Ireland.  Ryanair (RYAAY) also recently disclosed plans to launch the first low-cost trans-Atlantic airline in a matter of four years, a development we view as particularly ominous to trans-Atlantic yields.

The accord also poses risks to airlines currently enjoying oligopolistic pricing at Heathrow Airport, since the first phase of "open skies" will throw out Bermuda II transport agreement limitations (which restrict U.S.-Heathrow flights to essentially four carriers, namely  American , British Airways,  United , and Virgin Atlantic). Though Heathrow remains slot-constrained (read fully utilized), airlines that currently operate at nearby Gatwick (like  Northwest , Delta,  US Airways , and Continental), will soon be able to gain coveted access to Heathrow, either through slot exchanges with alliance partners or via the secondary market. Operators with existing rights at Heathrow--like British Midland Airways (bmi)--could also pressure fares as they shift capacity to trans-Atlantic flights from lower-margin short-haul routes within the EU.

And last but certainly not least, the new agreement could stimulate a wave of consolidation among European airlines. Since the EU will be viewed as one entity under the pact, carriers within the EU will soon be able to merge without losing their rights to fly to the U.S. market. We think that as carriers vie for valuable slots at Heathrow, British Midland Airways and Virgin Atlantic could eventually become merger candidates due to their coveted positions at the airport.

Mergers involving airlines on both sides of the Atlantic, however, will still be blocked, since the maximum foreign ownership of voting rights in U.S. carriers will remain restricted at 25%, at least under the first phase of open skies.

Temporarily Open Skies?
In fact, the hot-button issue of allowing foreign ownership of U.S. airlines will take center stage in coming years during negotiations of the second phase of open skies. Congress refuses to grant more liberal foreign ownership rules for U.S. airlines, while the EU allows U.S. companies to acquire up to 49% of European airlines--a major imbalance. Another important point during second-phase talks will involve granting European airlines the right to fly domestically within the U.S. (also known as cabotage)--similar to the concession granted to U.S. airlines, which will now be able to fly within Europe.

The long and short of the open skies pact is that if the U.S. government fails to grant these rights to European companies by the end of 2010, valuable concessions made by the EU during the first phase will likely be suspended or even withdrawn. The process of trans-Atlantic liberalization could essentially be stopped in its tracks, much like it has been in previous attempts.

Our Watch List
While hiccups can be expected and progress will be slow, we think the global liberalization of air travel is inevitable. If history is any indication, airlines will ultimately pass incremental rents gained through liberalization to customers in the form of lower fares. We think there are a few companies worth watching as the first phase of "open skies" gets set to kick off next year.

 Boeing (BA)
The pact largely validates our view that smaller twin-aisle planes will capture a significant portion of future long-haul travel. With the ultra-efficient 787 Dreamliner--the dominant aircraft in that segment--Boeing has wisely bet on the superior global demand for point-to-point flying. Though we currently capture a sharp upturn in smaller twin-aisle aircraft (including Airbus' A350 XWB) during our 20-year commercial aerospace forecast, continued liberalization of global air travel could result in further upward revisions to our already bullish long-term outlook.

 British Airways (BAB)
As slots are optimized at Heathrow due to the lifting of Bermuda II limitations, the carrier will eventually experience declining yields on flights to and from the London airport. We think it's possible that British Airways will become acquisitive if liberalization ends up taking a good chunk out of its trans-Atlantic profits. Though antitrust issues may pose an obstacle to such a merger, bmi (which currently holds 12% of the slots at Heathrow) could become an increasingly attractive takeover candidate, should British Airways look to thwart competitive incursions. Also, British Airways' involvement in a deal to take Spanish carrier Iberia private suggests that it will continue to take measures to ensure access to key markets.

 Continental Airlines 
Trans-Atlantic routes account for nearly 25% of capacity for the carrier, and we expect the airline to continue to expand aggressively across the Atlantic in coming years. Continental recently added five more Boeing 787 Dreamliners to its order book and has applied to the government for a lucrative Houston-Heathrow route. In the longer term, however, we expect yields to inevitably come under pressure as other carriers add capacity on the carrier's existing trans-Atlantic routes.

 Ryanair (RYAAY)
The carrier is currently in plans to build a fleet of 30 to 50 787s or A350s and launch the first true low-cost trans-Atlantic airline within the next four years. Low-cost carrier proliferation in the U.S. has wreaked havoc on yields and we would expect a similar impact across the Atlantic.

Marisa E. Thompson contributed to this article.