(FORTUNE Magazine) – EUROPE'S AIRLINES are going to war, albeit reluctantly. They are cutting quick deals with potential allies and whittling their forces to a lean, fearsome core. Says Frederick Reid, a Lufthansa senior vice president: ''We are braced for merciless change, and I don't think anyone can guarantee that there won't be real chaos.'' There will even be downward pressure on fares, though prices won't dive as much as they did in the U.S. The battle has been brewing for a long time, but the combatants didn't start scrambling until last June when the European Community passed a deregulation package that will remove most controls on airline capacity and fares, as well as abolish licensing rules to permit EC carriers greater access to markets in countries outside their home base. Few are well prepared. Most of Europe's airlines have been hammered cruelly by the global recession despite their longstanding regulatory protection. One prominent exception is British Airways, led by Chief Executive Colin Marshall. A scarred veteran of corporate battles in the U.S. -- Hertz vs. Avis in particular -- Marshall has in recent years used take-no-prisoners instincts to lift BA into the industry's highest ranks. BA last year was easily the world's most profitable carrier, netting $685.3 million on revenues of just over $9 billion, and Marshall is poised now to exploit his competitive edge as Europe's markets open up. Says he: ''There will be a number of sensible opportunities, and we will rapidly position ourselves in the most important markets.'' Jan Carlzon, chairman of Scandinavian Airline System, is also among the few industry leaders to anticipate the coming changes. He has long been predicting a bloody war of survival for Europe's airlines, and has looked for ways to cut costs to get ready for the struggle. Now he is rallying his troops with the imperative to make sure SAS is ''One of Five in '95.'' Says Carlzon: ''We have no choice; the time has come to jump into the cold water.'' In the U.S., deregulation not only shook out weak carriers, it also led to fierce price wars that handsomely rewarded passengers. The U.S. Federal Trade Commission has estimated that Americans saved about $100 billion during the first ten years after deregulation in 1978. The results will not be as dramatic in Europe, at least not in the near term. EC member states retain the right to object to any fare cuts they perceive to be predatory or anticompetitive. Most experts who study the industry also doubt that Europeans would respond well to marketing that promoted price at the expense of decent service. Frequent fliers in the U.S., now sullenly accustomed to brutish service and minuscule legroom, often long for the distant days of half-empty planes and friendly attendants. Top U.S. airline executives have found, however, that most passengers are still unwilling to pay more for the long-lost amenities. Price, and price alone, drives the U.S. market. In Europe, by contrast, a large number of low-cost charter operators siphon off the great majority of the vacation business. That leaves nearly all the more demanding -- and less price sensitive -- business travelers to the scheduled airlines. This crowd would be far less likely to tolerate the many privations suffered by U.S. passengers since deregulation. European flights are shorter too, and travelers always have the option of driving on modern superhighways or riding the fast, relatively cheap trains. Just 2% of travel between major European cities is by air, vs. 14% in the U.S. Says Robert Aying, BA's director of marketing: ''The U.S. industry seems to have accepted the thought that aviation is a commodity business, but our experience is that the public likes being looked after.'' In the coming struggle, carriers will use a number of ploys to protect their home turf, and these may slow the pace of change. Under the new regulations, an airline from one country will be able to serve several cities in another country but only as a continuation of an international flight. British Airways, for example, could fly from London to Frankfurt and then on to Berlin. Even so, it could fill only 50% of its seats with new passengers for the last leg. Unrestricted flying rights within another country, known as cabotage, will not be granted until 1997. The new rules also give EC member states plenty of loopholes to block the most serious forays of carriers from other European countries or from outside Europe; clauses and exceptions will permit governments to invoke fairness statutes and tie up invaders in miles of red tape. Except for British Airways, which was privatized in 1987, all of Europe's big airlines are at least partially government owned. Protectionist tactics are likely in any country where the national airline starts to flounder. Crowded airports and a chaotic air traffic control system will stifle competition too, limiting the number of startup airlines or new routes. Some 30 airports throughout Europe are at or near the point where traffic cannot grow. Only a half-dozen airports in the U.S. have reached that stage. Little can be done soon, because there isn't much land available and powerful environmental lobbyists oppose expansion. In the U.S., controllers can easily delay or redirect a flight thousands of miles away from its original course through a unified grid system that covers the country. Such maneuvers are far more difficult in Europe, where air- traffic control is a hodgepodge utilizing 55 control centers, 31 different control systems, 18 different computer hardware suppliers, 22 different operating systems, and over 70 different programming languages. EC officials are whacking away at the problem, but a single traffic-management system will not be in place until well after the year 2000. Says David Jennings, vice president for marketing at Airbus Industrie: ''What the rulemakers are trying to do may be a lot different from what actually happens. I'm not convinced you will see five or six carriers competing where there used to be one or two.'' OVER the longer term, though, competition is sure to heat up. One sure sign is mounting pressure on governments to sell their shares in flag carriers. British Airways' commercial success since getting out from under government ownership is encouraging others to try. The German government has already said it will sell its 51.2% share in Lufthansa. The majority, if not all, of Europe's big carriers will be privatized eventually because politicians will want to stop the drain on their national treasuries. To prepare for the open-skies competition likely by the end of the decade, most of Europe's carriers are looking hard at their operating costs. BA's ) Colin Marshall sliced nearly $500 million from his $8 billion budget last year and is trying to cut another $300 million or so this year. Air France is hoping to reduce its work force by 3,800 employees, or about 10%, by next year. Top officials at Lufthansa have wrested a one-year pay freeze and various productivity concessions from unions. Their eventual goal is to save from $300 million to $500 million by cutting jobs, routes, and the size of the fleet. Most of Europe's airlines are getting their hangars in order in other ways as well. Though each has been linked to one of two regional computer- reservation systems, Galileo International or Amadeus, most are just now mastering the sophisticated yield-management techniques they will need when fares float more freely. MERGER MANIA has broken out as weaker carriers seek safety through alliances and stronger ones use financial leverage to barge into new markets. BA bought a small German carrier, renaming it Deutsche BA, to operate within Germany. It has formed an operation dubbed Air Russia with various partners, including Aeroflot, and has held talks with the French airline TAT. Air France ensured its dominant position at home by buying the smallish UTA and the commuter line Air Inter, then acquired interests in Belgium's Sabena and Czechoslovakia's CSA. SAS has linked up in a loose arrangement with Swissair and Austrian Air, and Alitalia has sought to buy into the Hungarian carrier Malev. Says Air France Chairman Bernard Attali: ''Cannibalism has become a strategic model.'' While all this goes on close to home, a few European carriers are trying to bolster themselves by buying into U.S. airlines. BA is seeking a large share of USAir, KLM has sought an outright merger with Northwest, and Lufthansa has made a bid for part of Continental. (SAS took a stake in Continental in 1990 but lost it when the U.S. carrier declared bankruptcy this year.) Swissair has owned a small piece of Delta for some time. Though all the proposals seem to adhere to the letter of American laws governing foreign ownership of airlines, officials at the U.S. Department of Transportation have not yet figured out how to react. The big U.S. carriers want Washington to rebuff the foreign airlines unless American carriers get better access to European markets. A briefing paper prepared by the Big Three U.S. carriers -- American, United, and Delta -- fulminates that if the BA- USAir deal goes through ''the U.S. airline industry will either be sold off . to foreign interests, lose its ability to compete effectively in international markets, or both.'' For most of Europe's airlines, the greatest change of all will be in how they manage themselves. The majority of the carriers have long been operated as extensions of their governments, with all the accompanying bureaucratic sloth and political infighting. As the skies open up and the industry goes through the convulsions of deregulation, that sort of management guarantees disaster. Says Jean-Marie Mariani, director of corporate planning at Air France: ''It seems that every day you pick up the newspaper to find some big new development has taken place in our industry. This is new for us, and we must adapt and increase the speed of our reaction.'' Nimble management will be especially crucial for those carriers dependent on long-haul routes to Asia or across the Atlantic. The Big Three U.S. airlines have taken over such routes from TWA and defunct Pan Am and are threatening the Europeans' share of the huge transatlantic market. At the same time, fast- growing Asian carriers, some of which boast labor costs 20% to 40% lower than those at most European airlines, are increasing their presence on lucrative Asia-Europe routes. It adds up to a kind of triple whammy for European carriers, most of which are not yet hardened to the slash and thrust of unfettered competition. Says Louis Gialloreto, a management lecturer at Montreal's McGill University and close student of Europe's airline industry: ''While they figure out what they want to be when they grow up back home in Europe, these carriers may very well get hammered by the Americans and Asians on their international routes.'' IN THIS new world, size alone will not guarantee success. After all, Eastern Air Lines, now liquidated, was the biggest American carrier at the onset of deregulation in the U.S. Here are the likely prospects for Europe's biggest carriers, ranked in order of 1991-92 revenues: -- Air France: With its solid base at two airports in Paris, along with potential secondary hubs in Brussels, Lyons, and Prague, Air France has an enviable geographic reach. Its virtual monopoly on traffic within France also ensures a steady revenue flow. But costs remain relatively high, and unions will not make it easy to trim labor rolls enough to make a strong impact. Biggest negative: Management has been sheltered by an extremely protective government and has yet to be tested in an open marketplace. -- Lufthansa: After piling up huge losses over the past two years, management has finally tackled its inflated costs and unwieldy route structure. Labor outlays, which account for 32% of total costs compared with 24% at British Airways, will be the toughest nut to crack because of Germany's militant unions. By paring down its flight schedule, however, and continuing to add modern, fuel-efficient aircraft, the carrier is making some headway. Delta has begun to challenge Lufthansa's dominance at its prime international hub, Frankfurt, but secondary hubs at Munich and Berlin show promise. Lufthansa is also well suited geographically to dominate Eastern European traffic, which promises to grow quickly in the latter part of the decade. -- British Airways: BA brings some powerful weapons to the battlefield -- the lowest cost structure and biggest profits of any of Europe's big airlines, a war chest brimming with well over $1 billion, a seasoned management that has functioned without government interference or largess for over five years. In an evolutionary sense, this carrier is a generation ahead of its rivals and would seem ready to dominate. But BA desperately needs a solid foothold on the Continent to build secondary traffic bases, and it has so far been unable to reach agreement with a merger partner. Sporadic talks with KLM have proved fruitless, and Air France moved in and snatched Sabena from under BA's nose at the last minute. -- Scandinavian Airlines System: Chairman Carlzon has chipped away at sky-high costs while continuing to maintain a worldclass reputation for efficiency and service -- no easy feat. But the profit picture has been particularly glum at SAS because recession has battered both the airline and the string of international hotels owned by its parent company. The $100 million or so SAS lost in the Continental bankruptcy is less important than the North Atlantic traffic that will vanish if Lufthansa replaces it as partner to the U.S. airline. Most crucial to SAS's long-term health is finding one or more viable merger partners; because Scandinavia's relatively small population generates only limited traffic, the carrier cannot remain a major player without tying in directly to major urban centers on the Continent. -- Alitalia: This airline has some geographical blessings. Rome remains a top collection point for international traffic, and both Milan and Turin show promise as intra-European hubs. But negatives abound: high costs, an aging ; fleet, a reputation for indifferent service. Alitalia might best survive as partner to a carrier based far to the north, a BA or KLM say, so that the two could bracket the Continent and profit mutually from the traffic flow. -- Swissair: Costs are high and its parent country's population sparse, but Swissair has so far been able to charge premium prices and maintain reasonable profit margins because of ruthless efficiency and impeccable service. Despite the willingness of European travelers to pay for superior treatment, Swissair's positioning could be harder to maintain when the skies open up and downward pressure on fares takes over. Unless this airline joins up with one or more similar carriers in a solid financial partnership, it could be relegated to the uncertain status of high-quality niche player. -- KLM Royal Dutch: With its superb international base at Amsterdam and its pending merger with U.S. giant Northwest, KLM should be able to grab a solid share of North Atlantic traffic. To keep its planes filled back and forth from North America, however, KLM needs to get traffic from elsewhere in Europe. That means finding a merger partner, which will get harder to do after a while. -- Iberia: Its strategy of maintaining low costs and trying to fill its planes by charging relatively low fares has produced mountainous losses during the current recession. A merger partner based in central Europe could help some, as would improvement in service. Iberia's financial links to several airlines in Latin America promise to pay off in increased traffic on lucrative long- range routes on the southern Atlantic. For all these carriers, survival in the upcoming corporate battle will rest on the oldest of business principles. ''It all comes down to good management,'' says BA Chief Executive Colin Marshall. ''You've got to get costs under control, do some good creative marketing, and show an ability to take calculated risks.'' Some of the leaders of Europe's airline industry have already shown a grasp of what is needed; some haven't yet; some never will. As in every war, there will be casualties.

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