Oil and jet-fuel prices are in the stratosphere, many of the world’s top airlines have ordered severe cutbacks, and passenger traffic is falling, so why is Dubai funneling 82 billion of its petrodollars into an aerospace project that includes plans for the world’s largest airport?

The answer is simple. Dubai isn’t concerned about the near-term turbulence that has sent global investors diving for cover and induced airline-industry executives to hanger portions of their jetliner fleets. The leaders of that Middle Eastern country have taken a long and studious look at the powerful global trends that are destined to play out over the next 20, 30 or even 40 years, and have crafted their plans accordingly.

In a broad sense, that focus on the long term is a lesson U.S. investors would be very smart to follow.

So, let’s take a close look at how well Dubai’s financerati have thought this through. We’ll look at some moves you can make to profit alongside Dubai. And I’ll even let you in on a surprise conclusion about this project that we’ve reached here at Money Morning – that I can virtually guarantee you’ve yet to hear anywhere else. Perhaps you’ll be the enviable "person in the corner surrounded by a crowd" at the next dinner party you attend.

The Lowdown on a High-Flying Nation

Dubai is situated on the Southwest Coast of the Persian Gulf and is one of six jurisdictions that make up the United Arab Emirates, a member of the Oil Producing and Exporting Countries (OPEC).

Although Dubai built its economy on a foundation of petro-gusher dollars, "black gold" has become an increasingly smaller component of its market muscle. Right now, in fact, oil and natural gas account for only about 6% of Dubai’s estimated $40 billion economy, and some experts predict that its crude-oil reserves will be exhausted in about 20 years.

As ominous as that sounds, Dubai leaders apparently don’t see that as a catastrophe in the making. Today, the biggest pieces of this emirate’s economic might are based on foreign trade (16%), seaport or airport-located duty-free trade zones known as entrepot (15%), and financial services (11%), although real-estate development, construction and tourism are closing the gap quickly.

"Dubai had less oil than [neighbor] Abu Dhabi [and needs] to create jobs for the population," Richard Aboulafia, an industry consultant with the aerospace-management company, The Teal Group, told MarketWatch.com. "This is them saying: ‘Let’s convert our oil money into something tangible’."

Said Keith Fitz-Gerald, investment director for Money Morning: "What we’re seeing here is the emergence of an entirely new economy where the world least expected it. This is absolutely progressing much faster than anyone ever expected. And, to borrow an expression from an old movie, ‘There may be a new sheriff in town’," as global sovereign wealth funds potentially supplant Wall Street as the primary financing vehicle for the world markets.

Consulting giant McKinsey & Co. estimates that Persian Gulf economies will have to create more than 4 million jobs for its own citizens in the next 10 years. The aerospace sector could account for as many as 350,000 new positions by 2015, McKinsey says.

In very recent years, the country has gained a reputation for doing things in a big way, sometimes even past the point of excess. Dubai is already home to the world’s largest mall, biggest indoor ski resort and tallest building – as well as the world’s only "seven-star" hotel, the boat-sail shaped Burj Al Arab, a luxury hotel built on an artificially created offshore island, and a building whose reach of 1,053 feet makes it the tallest structure being used as a hotel anywhere on earth. And don’t forget "The World" itself, a much-ballyhooed manmade archipelago of 300 islands (situated in the shape of a world map). Most of the individual patches of land were to fetch $15 million to $50 million – although one of the islands was reportedly priced at $250 million.

Currently, an estimated $300 billion in construction-and-development projects are under way in Dubai.

Dubai Takes to the Skies

Dubai’s aviation vision reaches back several decades.  But it’s only really reached a critical mass in the past couple of years. Dubai-based Emirates Airlines is currently the world’s fastest-growing carrier. And that fast-climbing rate isn’t because Emirates is growing from a small base.

Indeed, with 180 jetliners, worth an estimated $58 billion, on order, Emirates has become such an industry heavyweight – especially when other top carriers are cutting their fleets – that U.S.-based Boeing Co. (BA) and pan-European aerospace giant Airbus SAS have actually catered elements of multi-billion-dollar airliner-development programs to the needs and demands voiced by Emirates execs.

"The Middle East is taking over the aerospace industry and Dubai is at the heart of it," Doug McVitie, an aerospace consultant with Arran Aerospace, told MarketWatch.com recently.

And that’s not just because of the major petro-bucks Emirates has at hand. It’s also because of how well the many pieces of Dubai’s growth strategy fit together.

Right now, globalization is the single most important business-and-economic trend unfolding in the world today. And thanks to that globalization – as well as advances in aerospace technology – the sheikdom whose proximity to India and willingness to slash trade taxes made it one of the Gulf region’s key trading outposts back in the 19th Century, once again finds itself at an opportune geographic nexus: From Dubai, it’s now possible to fly nonstop to the West Coast of the United States, or to the Far East – making it the logical stopping-off point for travelers flying between those two points.

"They have a geographic advantage that no one else has," Diogenis Papiomytis, a commercial-aviation consultant with Frost & Sullivan, told MarketWatch.com. "Within 8,000 miles, they can reach something like 80% of the world."

Emirates Airlines is reaping the benefits – and in a huge way. Last year, its profits soared 54%, reaching $1.45 billion. Sales jumped 32% as the airline carried more than 21 million passengers – an increase of 21% from the year before.

Right now, the Dubai carrier is watching its business grow at an annual clip of 15-18%. At that pace, and with the help of the passenger and cargo growth other carriers are experiencing in Dubai, Emirates Chief Executive Officer Maurice Flanagan says Dubai International will eventually overtake some of the world’s top airport hubs.

Overall, the existing Dubai International Airport had 34 million passengers – just about half that of the Global Top 3 of Atlanta’s Hartsfield-Jackson (85 million), Chicago’s O’Hare International (77 million) and London’s Heathrow International (67 million).

That’s why Dubai has decided to shoot for the moon and build the world’s biggest airport. A $33 billion development itself, the new Al Maktoum International Airport at Jebel Ali will have six parallel runways and will be able to handle 120 million passengers a year when it’s finished in 2015.

Holding Out For New Opportunities

But the airport itself is only a part of this $82 billion initiative. Dubai wants to become a global aerospace leader. And it’s deploying the Middle East’s favorite business weapon to do so – the holding company.

Middle Eastern players such as Dubai, Kuwait, Abu Dhabi and others use holding companies – financed by government-controlled sovereign wealth funds – as the investment-and-acquisition vehicles to achieve their economic objectives. Dubai, through its Dubai World holding company has been especially adept at using the holding-company strategy as an economic-development vehicle. And the emirate has created a new company, this one called Dubai Aerospace Enterprise, or DAE, which is to focus on the air-transportation sector.

DAE has already shifted into high gear, first recruiting former Honeywell Aerospace CEO Robert Johnson as its top executive and then establishing a number of operating subsidiaries – such as DAE University for training some of the 24,000 pilots the Gulf region will need in the next decade, and DAE Capital, which is buying and leasing aircraft to carriers throughout the world.

Dubai’s grand vision calls for the new airport to become an aerospace metroplex: It will be bigger than all of Hong Kong, and will consist of six different "zones," each with a different focus. Operations will include service and storage facilities for aircraft and cargo, production and assembly operations for aircraft components, and venues in engineering, training, and airport operations.

Though some analysts expressed concern about the risks and the poor timing, you can bet that this venture won’t fail. It’s not a profit-and-loss situation, given that its "investors" include the government-run Dubai International Capital sovereign fund, Dubai construction heavyweight EMAAR Properties PJSC, and the Dubai International Financial Centre, a 110-acre free-trade zone and international financial exchange.

Said the Teal Group’s Aboulafia: A lack of profitability "doesn’t matter. They are not a profit-and-loss-operation. They will scream until they’re blue in the face that they are not subsidized, but all the working capital comes from the government."

Here’s the surprising fact: Long-term, this project may turn out to be more than an airport. There’s actually been some conjecture that Dubai could well have plans to devote part of this project to space transportation, either as a commercial-satellite launch facility, or as a recovery area for returning reusable space vehicles – making this one of the first commercial spaceports on earth.

Whatever the ultimate plans are, it’s very clear that Dubai is determined to succeed. But many of the Dubai-based companies are private, and not publicly traded, and those that are public have their shares listed on Middle East bourses, and don’t have U.S.-listed American Depository Receipts (ADRs). And though we’d all love to ride along as investors in one of the big sovereign funds that are spreading billions around the planet, that’s not likely either.

But there are two very clear profit plays here, and one – pardon the pun – flyer.

Fly in Formation on an $82 Billion Project

Boeing is the most-obvious play here, given that it’s one of only two remaining successful jumbo-jet makers on earth (as I reported here a month ago, China just announced plans for a jumbo-jet company of its own, but that’s at least a decade away).

Boeing will reap billions in airliner orders from the Middle East (England’s Farnborough International Airshow – when billions of dollars worth of airliners are often ordered by carriers and leasing firms during flush times – is scheduled for mid-July) over the next several decades. And that market is dwarfed by the massive demand that’s expected to emanate from Asia: China alone is projected to require $340 billion worth of commercial airliners over the next 20 years.

The company’s defense business is sound, and it just won a favorable ruling from the U.S. General Accountability Office on a protest it lodged over the loss of a U.S. Air Force aerial tanker deal worth an initial $35 billion – and with a potential ultimate value of $100 billion.

At yesterday’s close of $68.21, Boeing’s shares are down 37% from their 52-week high of $107.83. The shares are trading at about 12 times current earnings and 17.5 times projected profits, and carry a dividend yield of nearly 2.4%. What’s more, Boeing has been buying back its own shares, which is often a good sign for shareholders.

Emirates CEO Flanagan – and others involved with the Dubai aerospace project – say the dour outlook for airlines is only temporary and will eventually work itself out. When that happens, we believe Boeing’s shares will definitely move higher – if not before.

MGM Mirage (MGM) is the other key play here. We like the shares of this Las Vegas-based casino-resort operator a lot for several reasons. First, the company is actually a high-profit play on China. And for followers of major global trends, that’s a huge plus.

But MGM also has a very strong tie-in with Dubai, because it already has in place a financing deal from the state-run Dubai World. Last summer, when MGM shares were trading in the $80 range, Dubai World said it would invest $5 billion in MGM.

The goal: Help MGM execute its China strategy, which the Vegas gaming firm has been pursuing since the middle 1990s.

And China is far from MGM’s only target market overseas. It’s working with the Mubadala Development Co. in both Dubai and Abu Dhabi on some similar luxury-level [non-gaming] projects. Mubadala is an investment arm of the Abu Dhabi government.

MGM is on the verge of becoming a top global brand in the hospitality sector, and Dubai wants a piece of the action. You can bet that as Dubai develops its airport property, and throttles up its global tourism strategy, MGM will be a key participant, given that Dubai already owns part of the company.

"Dubai is getting in on the ground floor of some very powerful trends," Money Morning’s Fitz-Gerald said.

U.S. brokerage houses are downgrading the shares because of a big drop-off in traffic in Vegas. But, to borrow a phrase, that’s not where the action is – or, at least, isn’t where the future action is going to be.

At yesterday’s close of $36.60, MGM’s shares are down 64% from their 12-month high.

If you want one highly speculative play – based almost solely on the hope for takeover – make a study of out-of-favor aircraft leaser Genesis Lease Ltd. (ADR: GLS). The Ireland-based firm has seen its shares drop about 64% from its 12-month high as the credit crisis and the airline-industry downturn savaged the sector. But some experts wonder if DAE Capital might not take this opportunity to grow a bit faster by picking up assets at a discount.

"The level of ambition and the money and willingness to support [the airport project] is staggering," David Stewart, a consultant with AeroStrategy, told journalists.
News and Related Story Notes:

• Money Morning Analysis:
  10 Global Trends to Follow for the Next 18 Months.

• Money Morning Economic Forecasting Series:
  Outlook 2008: Three Ways to Profit From Sovereign Wealth Funds – the "Next Wall Street."

•  MSNBC:
  Dubai’s seven-star hotel; Silly or sublime? Regardless, the Burj offers exceptional service.

• Wikipedia:
  Developments in Dubai.

• MarketWatch.com:
  Dubai’s $82 billion aerospace gamble. Center of gravity of aerospace industry is shifting east

• Wikipedia:
  The World.

• MarketWatch.com:
  Undaunted by oil, Emirates won’t slow expansion.

• Money Morning Financial Analysis:
  China’s Growth Will Clear $340 Billion Worth of Airliner Sales for Takeoff Over the Next 20 Years.

• Money Morning Financial News:
  Boeing Buying Back Shares, Announces Dividend Payout.

• Money Morning Financial Analysis:
  China Seeking Superpower Status With Jumbo Jet Deal.

It’s one of the biggest product-development programs in Asia right now, and it could easily determine whether Japan remains a global industrial powerhouse – or limps into the future as an international has been.

More than 30 years after Japan’s only airliner program since World War II ended as a commercial failure, the country is making a multi-billion-dollar bet that it can succeed in the jetliner market.

Japan’s Mitsubishi Heavy Industries Ltd. (PINK: MHVYF) has unveiled a plan  to develop a "regional" jetliner for use by airlines all around the world.  The controversial project gained global credibility in recent weeks after analysts began to speculate that Toyota Motor Corp. (TM) – the world’s No. 1 automaker by sales – would join the development team. Toyota subsequently confirmed its involvement, announcing plans to take a 10% stake in the venture and injecting $67 million to help get the initiative off the ground. The Japanese government is backing the program.

It’s a big gamble for Mitsubishi and its partners: The regional airliner market is right now dominated by Bombardier Inc., of Canada, and Embraer (Empresa Brasileira de Aeronautica SA) (ERJ) of Brazil. And firms in both Russia and China – each with a major U.S. corporation as a partner and co-pilot – already have targeted this market, and have a solid head start on the Mitsubishi team.

Still, the potential payoff is hefty enough to warrant the risk. Such key global trends as rocketing fuel prices, soaring global travel, fast growth in Asia, Latin America and the Middle East, and ongoing problems with major air carriers across the world are stoking worldwide demand for efficient, economic regional jets. And that demand could persist until 2030, many experts predict.
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"In terms of the macro picture, demand is there for this type of jet," Mizuho Investors Securities Co. Ltd. senior analyst Yuichi Ishida told the Reuters news service. "Money-losing regional routes could turn profitable by using them. But the real question is whether there is room left in this market for Mitsubishi Heavy."

To date, the so-called NAMC YS-11 – a turboprop airliner built by a Japanese consortium – is the only commercial aircraft made in Japan in the post-World War II era. The program was initiated by Japan’s Ministry of International Trade and Industry in 1954. The aircraft was rolled out in 1962 and production ended in 1974 – hardly qualifying it as a "success" from a financial standpoint.

Toyota’s Desire to Fly

Toyota said its motivation was primarily patriotic – the Mitsubishi jet is being backed by the Japanese government, which is searching for ways to for its smallish aerospace business to become more of a global player, especially after losing other industries to South Korea and China.

Toyota – which edged ahead of General Motors Corp. (GM) in the first quarter to become the world’s top-selling automaker – said it also would be looking for ways to adapt the technological know-how developed in its aerospace activities to its core automaking business. That’s not just an empty claim made to justify its diversification into the aerospace sector: The Mitsubishi MRJ70 (70 seat) and MRJ90 (90 seat) jetliners are to be the first regional jets to make extensive use of high-strength/lightweight "composite" materials, such as those found on the new 787 Dreamliner being developed by U.S. aerospace giant, The Boeing Co. (BA).

Although it hasn’t built a commerical aircraft in decades, it is an experienced subcontractor in that area, and is a veteran defense contracting firm. For example, Mitsubishi already is a key manuacturing partner on the long-range Boeing jet. And it has experience building such military aircraft as the F-1 fighter, T-2 trainer – both supersonic jets that the company built on its own – and the F-2 fighter, a Japanese-built version of the U.S. F-16 Fighting Falcon that was produced in partnership with Lockheed Martin Corp. (LMT)., the No. 1 U.S. defense contractor.

Toyota, too, has some experience, and already operates a small aerospace research team. Analysts say that venture could easily take flight and become a major business operation. That’s just what happened with Toyota’s robotics business, which started out as a fairly tiny research operation, but today is one of the company’s better-known businesses outside its core auto operation.

Honda Motor Co. (HMC), Toyota’s chief rival in Japan, already has expanded into the aircraft business; its futuristic seven-seater HondaJet light business jet has garnered heady praise for its advanced design and elegant lines. The company was supposed to start taking orders for the airplane sometime this month.
Toyota’s investment in the Mitsubishi jet is the largest of any company outside the Mitsubishi corporate network, or "keiretsu" of related companies. Other backers include domestic Japanese trading companies and the government-supported Development Bank of Japan. Foreign suppliers also will be involved.

 To Market, To Market

Why is Mitsubishi – Japan’s largest producer of machinery – getting into the airliner business? In a word: Opportunity.

Over the next 20 years, Boeing itself is forecasting that air carriers worldwide will need to acquire 28,600 commercial aircraft of all types – with a potential value of $2.8 trillion. The Boeing forecast is generally viewed as the world’s best analysis of the future global market for commercial airliners and cargo aircraft.

The huge revenue potential in the global airliner market – combined with the low number of viable competitors and the high barriers faced by new potential entrants – is a big reason that Money Morning’s investment gurus have repeatedly mentioned Boeing as a promising global investment for years to come.
During that same 20-year stretch addressed by Boeing’s market forecast, China will have to buy 3,400 airliners, a requirement worth $340 billion. That will make China the fastest-growing airliner market in the world, and will also rank it as the biggest market outside the United States for new commercial airliners. In fact, if you average it out, from China alone you’re talking about sales of $17 billion a year for the next two decades.

This staggering shopping list will include the globetrotting tarmac queens being built by Boeing and European rival Airbus SAS.

But global forces also are revving up demand for regional jetliners, like those being dreamed up by Mitsubishi.

According to Mitsubishi, the world’s airlines will order 5,000 regional jets over the next two decades as global carriers seek out fuel-efficient airplanes for shorter routes and developing nations expand their airliner fleets to fuel economic growth.

That’s not an arbitrary figure, either: The company spent several years analyzing the market and projecting the potential demand for the jet, and designed the specifications specifically around its findings. The plane will be:

• Small, so it can fly out of regional airports.
• Made of lightweight composites to make it strong and fuel efficient.
• Fast (with cruisng and maximum speeds of between 0.78 and 0.82 times the speed of sound, according to published reports).
• Profitable to operate, carrying 70 to 90 passengers, depending upon the model.
• And with a good range – 920 nautical miles for the base model, although extended-range (1,400 nm) and long-range (1,960 nm) versions will be available.

"Mitsubishi Heavy has always been just a partner of Western aircraft makers," Mitsubishi Heavy President Kazuo Tsukuda said at a news conference that talked up the company’s pet project. "Now we want to take advantage of changes in the marketplace such as high fuel costs and a greater need for environmentally friendly aircraft."

But here’s the problem: Mitsubishi isn’t the only player to see that potential.

And the competition figures to be pretty intense.

Just look at Vietnam: With all the changes that country’s economy is enduring, and with all the aircraft that will need to be upgraded to keep pace with global competition, Vietnam could well serve as a case study for the swirling market dogfight that Mitsubishi is accelerating into.

The Impact of Global Change

The over-under action should be interesting. Vietnam’s domestic carriers – state-owned Vietnam Airlines and joint-stock Pacific Airlines – will soon be forced to make room on that nation’s runways for some privately operated rivals, according to a recent report by the VietNamNet Bridge news service. Vietjet Air will be the first wholly private firm when it launches its domestic service late this year or early next year. When that happens, it will actually be the fourth carrier in Vietnam, joining Vietnam Air, Pacific Air and cargo carrier Vasco (Vietnam Aviation Services Co).

And state-run Vietnam Air is soon to be privatized, meaning it will have to modernize its fleet of 45 aircraft, a mix of aging Airbus, Boeing, ATR and Fokker commercial planes if it’s to compete against the new domestic rivals – and the host of foreign competitors that count Vietnam as one of their stops.

"We want to be one of the leading regional carriers," Bach Quoc Thang, Vietnam Airlines’ general manager for corporate affairs, said in an interview earlier this year. "Singapore Airlines and Cathay Pacific are the examples we want to follow."

According to some industry sources, Vietnam’s main carrier also may look to transform subsidiary Vietnam Air Service Co. into a low-cost carrier, to take on Pacific Airlines, part-owned by Australia’s Qantas Airways Ltd., and Malaysia’s AirAsia Berhad, now in partnership with Vietnamese shipbuilder Vinashin.
To secure financing for any new planes, Vietnam now has a newly established leasing company – its first – which has been capitalized with $200 million from Vietnam Air, Vietindebank, Petrovietnam and telecom group VNPT.

Here’s where it gets interesting. Vietnam Prime Minister Nguyen Tan Dung must soon decide which long-range jets to buy for Vietnam Air; that’s why both Boeing and Airbus have intensified their lobbying efforts.

Canada’s Bombardier has zoomed into the fray, as well, boasting that its newly launched CRJ900 NextGen regional 90-seater jet could fly domestic Vietnamese air routes and even key Asian routes at the lowest fuel cost per passenger seat – a key industry metric. It even flew one of the jets to Vietnam recently, to put the aircraft through its paces for this possible buyer.

"This would be an ideal feeder aircraft for Vietnam’s domestic and regional air transport needs," Trung Ngo, a vice president of Bombardier, told a Vietnam news service, adding that airlines such as Deutsche Lufthansa AG and Air France KLM have used its jets since the 1990s.

That would also be the ideal use for the Mitsubishi jet. But here’s the problem for Mitsubishi: Its airplane won’t be ready until 2013. That makes it too late for the initial sales push that will be taking place in this market, although experts say there will be many more opportunities in Asia and other parts of the world as markets abroad continue to open up to capitalism.

Big Returns Often Demand Big Risks

Demand for smaller jets is expected to increase rapidly as carriers bolster domestic routes and look to offset surging oil prices with aircraft that consume less fuel and are more likely to have their seats filled.

But Mitsubishi is not the only newcomer in the market.

Russia’s United Aviation Co. has teamed up with Boeing to build a jet for 75 to 95 passengers. China’s ongoing effort to build a midrange commercial jetliner got a boost recently when the leasing arm of U.S. giant General Electric Co. (GE) signed a preliminary agreement to buy five of the airplanes when they’re finished by the state-run venture in charge of the project.

China has broad ambitions in jet manufacturing, starting small with its 70-seat ARJ21-700, reports the trade journal Aviation Week & Space Technology. Flight testing has slipped a bit and now the certification of the aircraft isn’t expected until the middle of next year. Russia has a big aerospace sector, and wants into the regional market with its Sukhoi Super Jet 100, which will be in flight-testing soon.

Mitsubishi has set up a special subsidiary to oversee development of the jet. It capitalized the project with an initial outlay of $30 million, although it expects that total to climb to nearly $1 billion over the next year. Two-thirds of that money will come from Mitsubishi.
And that billion dollars is just the first installment.

Total development costs are projected to reach $1.5 billion to $1.8 billion – roughly equal to three years’ worth of the company’s profits. And that estimate is almost certainly short of what will really be needed, given the company’s newness to the sector and the new technologies involved.

Mitsubishi Heavy expects to lose money on the aircraft business for the next decade, and will underwrite the development costs with money from such cash-flow-positive business units as those that make and sell nuclear reactors and turbochargers. Many analysts question the wisdom of the strategy.

"It seems there are various sectors they’d be much better concentrating on, such as nuclear reactors," Takeshi Osawa, senior fund manager at Norinchukin Zenkyoren Asset Management, told Reuters. "There is demand for the planes, but the competition is tough."

Mitsubishi Heavy said it would buy 60% to 70% of the components for the new airliner from suppliers outside of Japan. For instance, it sees the Pratt & Whitney unit of United Technologies Corp. (UTX) as the engine provider.

Ironically, up until now, Mitsubishi’s aerospace business has filled that supplier/provider role, developing and making parts for Boeing and Airbus jets. It makes cargo doors for Airbus jets and the composite wing box for Boeing’s new Dreamliner.

Support and Opposition Abound

All Nippon Airways Co. Ltd., Japan’s No. 2 air carrier, gave the Mitsubishi jet project a vote of confidence recently when it committed to purchases of 25 of the jets. And Steven F. Udvar-Hazy, chief executive officer of aircraft leasing giant International Lease Finance Corp. (ILFC), told Aviation Week that his firm has met with Mitsubishi and has made a series of recommendations for improving the design of the MRJ jetliner. ILFC also has been in talks with Bombardier about buying that company’s proposed C-Series jet.

"What I have told [Mitsubishi] is … if you guys can pull it off and do what Toyota has done in cars, you can be a formidable player," Udvar-Hazy told the influential aerospace-industry trade journal. "But it has to be done right."

Needless to say, Udvar-Hazy’s major concern is the price of the airplane.

One potential rival says Mitsubishi can expect to face some real marketplace turbulence. Although it already has one airline backer in Japan-based All Nippon Air, the technology Mitsubishi is offering may not be unique enough to differentiate it from all the other marketplace offerings, Frederico Pinheiro Fleury Curado, the CEO of Brazil’s Embraer, alleged during a recent interview with Aviation Week..

When it comes to the Mitsubishi project launch, "the timing is not ideal," Curado said. "It will take a few years to see what should be included on next-generation aircraft, which is not clearly defined right now."

Aircraft with true next-generation technology won’t hit the market until 2016 or 2017, he contends. That means the Mitsubishi jets will hit the market a few years before new technology redefines the market that the Japanese firm hopes to capture.

"Even using today’s technology and doing everything right, the MRJs will not be materially better than the Embraer 170/190 family. They will be caught between two generations of aircraft," Curado contends.

While conceding that Mitsubishi will be a strong competitor, Curado insists the company is not the kind of threat that could jeopardize Embraer’s future. At the same time, however, he sounded concerned about the Japanese government’s deep pockets – and what financial backing of that magnitude might do to Embraer.

"And a point we made strongly to the Japanese press is that it would not be tolerable for its government to subsidize the [MRJ]," he warned.

Because Japan is a member of both the World Trade Organization (WTO) and Organization for Economic Cooperation and Development (OECD), there are rules the country must follow – and that includes no subsidies, he stated.

Mitsubishi Heavy said it hopes to have the jet in the air by 2013 and will aim to sell 1,000 over the next 20 to 30 years, grabbing one-fifth of expected new demand in a market that is projected to roughly quintuple to more than 5,000 planes by 2026.

News and Related Story Links:

• Corporate Web Site:
  HondaJet.

• The Financial Times:
  Toyota funds passenger jet.

• Reuters:
  
  Japan’s $1 billion plane project gets off the ground.

• Aviation Week and Space Technology:
  Embraer Chief Questions MRJ70/90 Launch.

• Aviation Week and Space Technology:
  Mitsubishi Leads Japanese Aircraft Resurgence.

• Money Morning Special Investment Report:
  China’s Growth Will Clear $340 Billion Worth of Airliner Sales for Takeoff Over the Next 20 Years.

• Money Morning News Analysis:
  Boeing Earnings Surprise Wall Street Just One Day After Weak Dollar Forces Airbus to Raise Prices.
• Forbes:
  Boeing, Airbus, Bombardier compete to sell jets to Vietnam.

• VietnamNetBridge:
  Private airlines ready for take-off.

• AerospaceTechnology.com:
  Bombardier CRJ900 Regional Jet, Canada.

• Wikipedia:
  NAMC YS-11.

• Wikipedia:
  F-2 Fighter Jet.
• Money Morning Economic Forecasting Series:
  Outlook 2008: Three Ways to Profit From Sovereign Wealth Funds – the "Next Wall Street."

• Wikipedia:
  F-1 fighter.

• Wikipedia:
  T-2 Supersonic Trainer.

• Wikipedia:
  F-16 Fighting Falcon.

• Wikipedia:
  Fokker.

Continental Airlines Inc. (CAL) said it would forgo a merger with UAL Corp.’s (UAUA) United Airlines unit, while all-business-class carrier Eos Airlines Inc. ceased operations after filing for bankruptcy protection – two weekend developments that illustrate the escalating pressures that domestic air carriers continue to face.

Continental’s management ended months of speculation by announcing that a merger with troubled United would do more harm than good, even with the intense pressure airlines are under due to record high oil prices and the competitive threat posed by the recent deal between Delta Air Lines Inc. (DAL) and Northwest Airlines Corp. (NWA).

"The risks of a merger at this time outweigh the potential rewards,” Chief Executive Officer Larry Kellner said in a letter. "While some would prefer to see Continental pursue a merger, we strongly believe we have made the right decision."

As for the niche carrier Eos, in grounding itself it joins Skybus Airlines, Aloha Airgroup Inc.’s Aloha Airlines and ATA Airlines Inc., which have already ceased operations, as well as U.S. charter operator Champion Airlines, which announced plans to stop flying at the end of May.

Frontier Airlines Holdings Inc. (FRNT) also has filed for bankruptcy protection, but at this time plans to keep flying.

The Eos downfall was "no surprise," Calyon Securities airline analyst Ray Neidl told The Associated Press. "We saw it happen with other smaller, undercapitalized airlines. Basically, there are too many airlines. We’re in a period of consolidation. The weaker guys, [facing] $120-a-barrel oil, are finally succumbing."

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With jet fuel the single largest expense for carriers, merging to capitalize on economies of scale makes sense. And as the world’s new largest carrier, the Delta/Northwest merger now has the competitive advantage.

But while Continental still might be able to go it alone – even against a stronger potential rival – United is in a much weaker financial position and needs a partner. The carrier wasted no time in turning its attentions to U.S. Airways Group Inc. (LCC).

"Consolidation is under way – ensuring you have the right partner is everything," United Airlines Chief Executive Glenn Tilton said in a statement. "We will pursue all options to ensure a strong, sustainable future for our airline."

While talks with U.S. Airways are not yet at the advanced stage United had reached with Continental, management is doing its best to accelerate discussions, hoping to finalize any deal before the end of the year – and before there’s a possible change in the political party in the White House.

When it comes to mega-mergers – and industry consolidations in which there might be a perceived decline in competition – the Bush administration is seen as being more of a proponent for deals that require Justice Department approval in order to proceed.

Analysts say that U.S. Airways and United could mesh well due to similar pay structures and complementary fleets. In addition, United and U.S. Airways are both members of the Star global marketing alliance.

Bigger is Better

Atlanta-based Delta announced it would buy the Eagan, Minn.-based Northwest for $3.63 billion, all in stock, creating a single carrier with a combined enterprise value of $17.7 billion.

Delta Chief Executive Richard Anderson will be chief executive officer of the combined company. Delta Chairman Daniel A. Carp will become chairman of the new Board of Directors.

The carriers decided to go ahead with a merger despite being their respective pilot’s unions being unable to come to agreement. Delta’s 7,000 pilots endorsed the deal by supporting a new labor agreement that includes an equity stake.

While Northwest’s 5,000 pilots will be asked to join a contract before the deal closes, the union is expected to oppose deal after the unions could not agree on how to assign pilot seniority – a key determinant of shifts, pay scale and what airplanes they fly – in the new organization.

It is expected that the Delta/Northwest merger will be approved later this year.

News and Related Story Links:

• Bloomberg News:
  Continental Air to Shun Mergers, Remain Independent

• Reuters:
  Continental not merging with UAL; seeks alliance

• The Associated Press:
  All-business-class niche airline Eos folds

• Forbes:
  UAL, USAir merger talks advance – sources

• Money Morning:
  Troubled Global Airline Industry Battered by Fuel Costs, Labor Problems

• Money Morning:
  More Airline M&A Expected on Heels of Delta’s $3.63 Billion Northwest Acquisition

Just one day after arch-rival Airbus SAS was forced to raise prices because of a weak dollar, The Boeing Co. (BA) said yesterday (Wednesday) that its first-quarter profits soared 38%, easily eclipsing Wall Street expectations.

Shares of the world’s No. 2 commercial jetliner-maker soared $3.53 each, or 4.49%, to close at $82.09 because of Boeing’s record backlog and a bullish outlook for next year. Earlier yesterday the shares touched $83.36, the biggest increase since June 2006.
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Investors had pushed the stock down 15% in the quarter over worries about delays in the "Dreamliner" jetliner program, and the surprise loss of a $35 billion U.S. Air Force tanker contract to a team that included Airbus and U.S. defense contractor Northrop Grumman Corp. (NOC).

Boeing is one of the companies that Money Morning has written about repeatedly, having identified it as a so-called "Global Titan" – a company that’s positioned to capitalize on worldwide trends and that derives the bulk of its sales and profits from such fast-growing overseas markets as China. Jetliner deliveries rose 8.5% last quarter, with almost two-thirds getting delivered overseas.

Profit from continuing operations rose to $1.21 billion, or $1.61 a share, from $873 million, or $1.12, a year earlier, the Chicago-based Boeing reported. Sales advanced 4.1% to reach $16 billion. The results beat the average estimate of $1.35 per share, according to a survey of 20 analysts conducted by Bloomberg News.

Profit for 2009 will be $6.80 to $7 a share on sales of as much as $73 billion, Boeing said in its first forecast for 2009. That projection also exceeded expectations: Analysts had predicted that profits would increase from about $5.93 a share this year to $6.87 next year – even after about a dozen estimates had been slashed after Boeing announced another delay in its 787 Dreamliner program, the third time the airliner maker has pushed back the scheduled first flight for the high-tech commercial jetliner. But the company announced a record backlog.

"We are encouraged that they added to the backlog in the first quarter," Eric Marshall, research director at the Dallas-based Hodges Capital Management, said in a Bloomberg Television interview. Delays to the 787 Dreamliner program, which dragged down Boeing’s stock price this year, have "created an attractive opportunity for long-term investors. We think the stock could go back above $100 over the next year," which is why Hodges is adding to its Boeing position of 330,000 shares.

From yesterday’s close, a move to $100 would represent a return of 22%. And that doesn’t include income from Boeing’s current dividend yield of 1.95%.

Weak Greenback Stings Airbus

With a decline in the greenback of nearly 9% so far this year, Boeing has gained an advantage over its bureaucratic European rival, Airbus. Most of Airbus’ costs are euro-denominated, while Boeing’s sales are conducted chiefly in dollars.

Airbus, currently the world’s biggest maker of commercial aircraft, said it’s raising the price of its planes in response to the dollar’s decline against the euro, and to offset an escalation in metal prices fueled by the ongoing global commodities boom.

The list price of the single-aisle Airbus A320-series jet will rise by an average of $2 million as of May 1, while twin-aisle airliners will typically cost $4 million more, the Toulouse, France-based Airbus said Tuesday.

"The price increase is mainly triggered by the weak U.S. currency and the overall increase of the world’s raw-material prices, especially with regards to metal," Airbus said.

The falling dollar hurts earnings at both Airbus and its parent company, European Aeronautic, Defence & Space Co., when revenue from dollar-denominated aircraft sales is "translated" into, or converted into, European euros.

Metal costs also have crimped profits, as the price of aluminum alone has soared 28% just this year, due to supplies constrained by rising purchases in China, and shortages of energy needed to make the lightweight metal.

Conversely, a weakening dollar makes foreign purchases of Boeing aircraft cheaper – almost as if the buyers are getting a price cut. But since Boeing doesn’t have to convert those dollars into a different currency, the "price break" buyers are getting has no effect on its revenue or profit.

Boeing also is getting a boost as carriers such as Continental Airlines Inc. (CAL) buy more of the U.S. airplane-maker’s Boeing 737-class jet to replace older, less fuel-efficient aircraft to reduce the effect of record oil prices. Unfilled commercial orders rose to an unprecedented $271 billion.

Boeing Chief Executive Officer W. James McNerney Jr. had held back his annual forecast until yesterday to learn more about delays in the Dreamliner, which is at least 14 months behind schedule and won’t enter service until late 2009.

Boeing said that its commercial sales rose 8% to reach $8.16 billion, generating a 39% jump in operating earnings, while Boeing’s military business saw sales fall 1.8% to reach $7.58 billion, even as profit increased 10 percent. Boeing is also the second-largest U.S. defense contractor, trailing Lockheed Martin Corp. (LMT).

Boeing said today it expects to deliver 500 to 505 airliners in 2009 – up from as many as 480 this year. Asia is expected to be a major market going forward, as will be China. Consider that:

• The global demand going forward is almost beyond belief. China alone will require 3,400 new airplanes worth about $340 billion over the next 20 years – an average of $17 billion annually. And that doesn’t include other Asian markets, such as Vietnam, which will need to modernize their air fleets as they commercialize their commodities.
• The Vietnam deal announced in November is worth $1.9 billion.
• In fact, over the next two decades, Boeing has forecast that air carriers worldwide will need to acquire 28,600 commercial aircraft – with a value of $2.8 trillion.

Boeing spent $1.2 billion last quarter to buy back 15.6 million shares, part of a $7 billion repurchase authorization. Thirteen of 24 analysts in a Bloomberg survey recommend the company’s stock; nine say to hold it, and two recommend selling.

Founded in Seattle by timber millionaire William E. Boeing back in 1916, the company got its start building seaplanes and operating a series of air transport services.  In 1933, Boeing built the world’s first true commercial airliner, the Boeing 247, which was all metal, instead of the conventional wood, fabric and metal construction of that time.

But the company really came to prominence in the late 1930s, in the depths of the Great Depression, when it made a bet-the-company decision to develop a long-range Army Air Corps bomber on spec. The four-engined aircraft was so impressive that an awestruck newspaperman dubbed it the "Flying Fortress." The name stuck. That airplane was the Boeing B-17, a heavy bomber without which most experts say the Allies might never had defeated Germany in World War II.

With the arrival of the jet age in the 1950s, the company risked its own capital to develop what eventually became the Boeing 707, a jetliner that leapfrogged offerings from Great Britain’s De Havilland, France’s Sud Aviation and Russia’s Tupolev – and revolutionized jet airliner travel in the process.  A subsequent model, the 737, is the best-selling commercial jet ever. Boeing’s double-decked, humpbacked 747 "Jumbo Jet" debuted in the late 1960s, and opened the door to true intercontinental travel.

Since World War II, Boeing has also been a heavyweight in the defense-aerospace sector, building long-range bombers, aerial tankers, missiles, and helicopters, among other weapons systems. The military-contracting business has helped Boeing through periods in which there might have been a lull in the commercial side of the company’s business.

News and Related Story Links:

• Bloomberg News:
  Boeing Profit Rises 38% on Record Backlog of Orders.

• Bloomberg News:
  Airbus to Raise Plane Prices on Dollar Decline, Steel.

• Money Morning Investment Analysis:
  China’s Growth Will Clear $340 Billion Worth of Airliner Sales for Takeoff Over the Next 20 Years.

High fuel prices are to blame for Delta Air Lines Inc.’s (DAL) and Northwest Airlines Corp.’s (NWA) first-quarter losses, the companies said separately.

For the quarter, Delta posted a net loss of $274 million, or 69 cents per diluted share. Northwest, which Delta agreed to merge with a couple weeks ago, posted a $4.1 billion loss, or $15.78 a share, which included a $3.9 billion non-cash expense and other costs.

Delta said in a statement that its fuel costs increased by $585 million year over year. Northwest phrased their pain at the pump slightly different, saying it paid $2.77 per gallon for jet fuel in the first quarter compared to $1.85 a gallon in the first quarter of 2007, nearly a 50% increase.

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With their losses in the books, all five major U.S. airlines posted losses in the first quarter – as the diving dollar and a slowing economy added the strain of skyrocketing gas prices. And to recover, carriers are bumping up prices accordingly while trimming the number of planes in the air.

"Our need to respond to the pressures of dramatically rising fuel costs and a softening U.S. economy drove us to take a closer look at all options to protect Delta’s future," Delta Chief Executive Officer Richard Anderson said in the statement. "The merger with Northwest will create an airline with the size, scale and global presence to weather economic downturns and compete long-term in the global marketplace."

U.S. Airways Group Inc. (LCC) is also expected to post a loss in its first-quarter earnings report, due today (Thursday).

Should that happen, the top eight U.S. carriers would all record first-quarter losses.

News and Related Story Links:

• Delta Air Lines Inc.:
  Delta Air Lines Reports March 2008 Quarter Financial Results

• Northwest Airlines Corp.:
  Northwest Airlines Reports First Quarter 2008 Results

• Associated Press:
  Earnings Preview: US Airways expected to post 1Q loss

Delta Air Lines Inc. (DAL) and Northwest Airlines Corp. (NWA) are now officially one company, and together now represent the world’s largest airline carrier.

The Atlanta-based Delta bought Northwest for $3.63 billion, all in stock, creating a single carrier with a combined enterprise value of $17.7 billion. The landmark deal is expected to ignite an industry consolidation wave, as small or struggling airlines go for size in order to compete with Delta’s newfound market heft at time when a slowing economy and soaring fuel costs are eviscerating profit margins for marginal players.

"Expect [the] dominoes to fall," Bear Stearns Cos. Inc. (BSC) analyst Frank Boroch wrote in a note to investors.

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Four smaller U.S. airlines have filed for bankruptcy in the past month – Frontier Airlines Holdings Inc. (FRNT), Skybus Airlines, Aloha Airgroup, Inc. and ATA Airlines Inc.

And now that the first major hurdle of Delta’s Northwest acquisition has been cleared, talks between UAL Corp.’s (UAUA) United Airlines and Continental Airlines Inc. (CAL) will elevate in priority.

Since 2001, U.S. carriers have shed more than 150,000 jobs and lost more than $29 billion.

Looking ahead, a report from Calyon Securities predicted the U.S. airline industry would lose more than $1 billion in 2008, mostly from the one-two combo of high fuel costs and shrinking demand, Reuters reported.  However, top carriers Delta and Southwest Airlines Co. (LUV) are best positioned to weather the storm, Calyon analyst Ray Neidl said.

The new Delta is expected to generate more than $1 billion annually in revenue, even as it streamlines operations and trims overhead. And its balance sheet will have an expected liquidity of about $7 billion at the close of the deal.

"Today, we’re announcing a transaction that is about addition, not subtraction," Richard Anderson, Delta’s Chief Executive Officer, said in a statement.

What’s In Store for Investors

Under the transaction’s terms, Northwest shareholders will receive 1.25 Delta shares for each Northwest share they own – a 16.8% premium based on April 14 closing prices.

The merger is subject to the approval of Delta and Northwest shareholders, and must also pass muster with regulators. It is expected that the regulatory review period will be completed later this year.

Board Members, Pilots Shuffled

Delta’s Anderson will be chief executive officer of the combined company. Delta Chairman Daniel A. Carp will become chairman of the new Board of Directors.

Northwest Chairman Roy Bostock will become vice chairman. Ed Bastian will be president and chief financial officer.

The board of directors will be made up of 13 members, seven of whom (including Anderson) will come from Delta’s board, and five of whom will come from Northwest’s board, including Bostock and Doug Steenland, the current Northwest CEO. One director will come from the Air Line Pilots Association (ALPA).

Delta’s 7,000 pilots sealed the agreement by supporting a new labor agreeing that includes an equity stake.

Northwest’s 5,000 pilots will be asked to join a contract before the deal closes, but Reuters reports that they will use "all resources available to aggressively oppose" the deal after the unions could not agree on how to work under one seniority umbrella, a key determinant of shifts, pay scale and what airplanes they fly.

News and Related Story Links:

• Money Morning:
  Troubled Global Airline Industry Battered by Fuel Costs, Labor Problems

• Delta Air Lines:
  Delta Air Lines, Northwest Airlines Combining To Create America’s Premier Global Airline

• Reuters:
  Airlines to lose more than $1 billion in 2008: Calyon

• Reuters:
  Delta, Northwest to create largest airline

Denver-based Frontier Airlines Holdings, Inc. (FRNT) – parent company of Frontier Airlines – announced Friday that it is has filed for Chapter 11 bankruptcy protection, citing unexpected problems with its credit card processor.

Frontier said it would continue normal business operations – operating its full schedule of flights and maintain employee wages, healthcare, vacation and other benefits.

President and Chief Executive Officer Sean Menke went into detailed length about the airline industry’s woes, how Frontier is holding up to them and what to expect in the next year.

"To be clear, we filed for very different reasons than those of other recent carriers, and our customers and employees can be confident that we intend to keep on flying and providing outstanding service and products," Menke said.

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"We felt that Frontier would be able to withstand the challenges confronting the U.S. airline industry, which include unprecedented and significant increases in the cost of jet fuel and the impact of the credit crisis in the financial markets, without seeking bankruptcy protection. Frontier has continued to perform relatively well in this difficult environment, and contrary to the trend, we have not seen a decrease in consumer demand, as demonstrated by our record traffic and revenue in March."

But its principal credit card processor – which remained nameless – unexpectedly informed the company that significant proceeds from ticket sales would be withheld beginning last Friday.

"Unchecked, it would have put severe restraints on Frontier’s liquidity and would have made it impossible for us to continue normal operations," Menke said.

Freefalling Airlines

The near freefall of the U.S. airline industry is strongly reminiscent of the downfall of financials that began tumbling last summer.

Like the financials, most of the airlines are suffering the same major problems – increased fuel costs, slowing demand and a weakening U.S. economy. At the same time, efforts to increase cost efficiencies through mergers have been blocked by labor unions.

And recently, nearly every U.S. carrier has felt the burn.

On Thursday, the world’s largest air carrier, American Airlines – principal subsidiary of AMR Corp. (AMR) – canceled 933 to continue inspections on MD-80 aircraft wiring. Last week alone, American cancelled more than 2,500 flights and stranded an estimated 100,000 travelers.

Two weekends ago, Skybus Airlines shut down operations and declared bankruptcy, becoming the third carrier in the span of a week to close its doors – joining the ranks of Columbus, Ohio-based carrier joined Aloha Airgroup Inc.’s Aloha Airlines and ATA Airlines Inc.

Delta Air Lines Inc. (DAL) and Northwest Airlines Corp. (NWA) have been in merger talks for months now, with a major holdup coming from the 12,000 pilots between them who’ve yet to endorse the deal.

Also in the merger arena, UAL Corp.’s (UAUA) United Airlines and Continental Airlines Inc. (CAL) had also started talks earlier this year, but negotiations are on pause as the two airlines are waiting to see what happens with Delta and Northwest, a source with knowledge of the matter told Reuters.

A report from Calyon Securities predicted the U.S. airline industry would lose more than $1 billion in 2008, mostly from the one-two combo of high fuel costs and shrinking demand, Reuters reported.  However, top carriers Delta, Northwest and Southwest Airlines Co. (LUV) are best positioned to weather the storm, Calyon analyst Ray Neidl said.

Frontier’s shares hit near rock bottom Friday, falling 69.43% to close at $0.48 per share.

News and Related Story Links:

• Frontier Airlines:
  Frontier Airlines Files for Chapter 11 Reorganization; Normal Operations Continuing and Unaffected

• Money Morning:
  Troubled Global Airline Industry Battered by Fuel Costs, Labor Problems

• Reuters:
  Delta and Northwest revive merger talks: report

• Reuters:
  Airlines to lose more than $1 billion in 2008: Calyon

When Skybus Airlines shut down operations and declared bankruptcy over the weekend, it became the third carrier in the span of a week to close its doors.

In grounding itself, the Columbus, Ohio-based carrier joined Aloha Airgroup Inc.’s Aloha Airlines and ATA Airlines Inc., which have already ceased operations, as well as U.S. charter operator Champion Airlines, which announced it plans to stop flying at the end of May.

The troubled airline industry has been beset by a host of problems on all sides as rising oil prices and a weakening U.S. economy have combined to take a big bite out of the carriers’ bottom lines. At the same time, efforts to increase cost efficiencies through mergers have been blocked by labor unions.

Airlines looked like they were battling back from a five-year slump following the 9/11 terrorist attacks, a period in which carriers rolled up $35 billion in losses. But while demand for air travel remains high, passenger satisfaction is at a historic low. Operational performance, which includes everything from on-time arrival to lost luggage, is at its lowest point in 20 years, according to the latest Airline Quality Rating study.

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"With the U.S. airline industry at rock-bottom in terms of overall perfor
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mance, greater accountability is necessary," said Brent Bowen, a researcher on the study who’s with the University of Nebraska at Omaha. 

Airlines are searching for ways to cut costs without adding to the already unpopular passenger charges and fees, especially as consumer spending wanes. Fuel is the biggest expense category for airlines, and with oil north of $100 a barrel and heading higher, consolidating to capitalize on economies of scale seems to make sense. 

Although a number of deals have been proposed, none have really been able to get off the ground.

Stalled U.S. Airline Merger

Delta Air Lines Inc. (DAL) and Northwest Airlines Corp. (NWA) have been in merger talks for months now. Several important issues have already been decided. The combined carrier will fly under the Delta name and will be based in Delta’s home city of Atlanta.

Delta Chief Executive Officer Richard H. Anderson will remain on as head. But the stumbling block in a deal that would create the largest domestic carrier is the endorsement of the pilots.

In the past, airlines have had the pilots hammer out a deal after a contract has been signed. But hoping to have a fully functional combined airline that much sooner, Delta and Northwest encouraged their pilots to negotiate as soon as the planned merger was announced.

Unfortunately, the extra time hasn’t helped. The two unions have been unable to come to an agreement on seniority, which affects pay as well as route selection and the types of aircraft flown for the 12,000 pilots involved in the merger.

Without an agreement, the two unions have refused to endorse the merger.

Labor union support is critical to any merger, as Delta’s pilots’ union was instrumental in derailing a hostile bid takeover by U.S. Airways Group Inc. (LCC). But without the merger, Delta and Northwest will be forced to implement other cost-saving measures, including raising fees and cutting jobs.

UAL Corp.’s (UAUA) United Airlines and Continental Airlines Inc. (CAL) had also started merger talks earlier this year, but negotiations are on pause as the two airlines are waiting to see what happens with Delta and Northwest, a source with knowledge of the matter told Reuters.

European Merger Woes

Meanwhile, across the pond, Franco-Dutch carrier Air France-KLM (OTC: AFLYY) is facing similar labor opposition to its buyout of Italian carrier Alitalia – Linee Aeree Italiane S.p A.

Alitalia recently suspended trading of its shares and is estimated to be losing almost $1.5 million (the equivalent of 1.0 million euro) a day. The struggling carrier desperately needs the merger to go through in order to survive. Without a much-needed capital infusion from Air France-KLM, the carrier will undoubtedly have to file for bankruptcy protection.

But unions failed to approve the Air France-KLM bid, which included a 10% staff reduction, a $1 billion capital infusion and an all-stock bid that valued Alitalia at $217.7 million (138 million euros).

Air France-KLM said on Monday this was "the only plan able to allow Alitalia to return to health swiftly," Reuters reported.

The Italian government is eager to divest its share of the financially unsound airline and Economy Minister Tommaso Padoa-Schioppa, the driving force behind the sale, has said unions must make a move fast or risk having the government appoint a special administrator to take over the negotiations.

With Italy’s elections looming on April 13 and 14, the government is eager to find a favorable solution.

News and Related Story Links:

• Reuters:
  Delta and Northwest revive merger talks: report

• Flightglobal.com:
  US Airways aims to quiet concerns in face of airline closures

• International Herald Tribune:
  Delta looking at Northwest request to go ahead with deal without pilot pact

• Reuters:
  Alitalia plays for time with survival at risk

• Money Morning:
  Air France-KLM Pins Hopes on Northwest Merger

Air France-KLM (AKH) is taking a unique interest in Delta Air Lines, Inc.’s (DAL) merger talks with Northwest Airlines Corp. (NWA) and UAL Corp.’s  (UAUA) United Airlines.

Air France-KLM, itself a product of a major airline merger, is one of Delta’s primary European partners under the SkyTeam Airline Alliance.  Northwest is also a member of the alliance and has a long history of close ties with Air France-KLM. By contrast, United is part of the Star Alliance, which includes main European partner and Air France-KLM rival Deutsche Lufthansa AG (DLAKY). 

And that’s why Air France-KLM is so interested in the outcome of a domestic U.S. carrier merger. Air France-KLM has been planning a joint transatlantic venture with Delta under the "open-skies" agreement for months now. It doesn’t want to lose Delta as an alliance partner, and if it can strengthen its relationship with Northwest at the same time, even better.

In fact, Air France-KLM is so concerned about the outcome of these merger talks that it may even assist with funding a Delta bid for Northwest, Bloomberg News reports. 

High Oil Costs Fueling Mergers

With oil over $90 a barrel and no relief in sight, airlines are feeling the pinch just like the average consumer.

"Every penny increase in a gallon of jet fuel costs our industry $195 million annually, and while we operate more efficiently, we must be able to pass commodity costs on to customers, as other industries do," UAL spokeswoman Robin Urbanski said in defense of United Airlines’ recent increase of its domestic fuel surcharge.

Higher costs make mergers seem like a good idea. Delta has been feeling the pressure from low-cost competitors like Southwest Airlines Co. (LUV) and just pushing the extra costs off onto consumers isn’t the best strategy. Fuel is the biggest expense category for airlines and consolidating to capitalize on economies of scale seem to make sense. 

But not everyone is convinced that a merger will solve all of Delta’s problems. 

"The question really is: how much more successful can a giant dinosaur be than two medium-size dinosaurs?" Peter Morris, chief economist of U.K.-based aerospace consultancy Ascend told MarketWatch.

The highly regulated domestic airline industry has many challenges beyond just high fuel costs. Airlines have a host of labor problems at every level from pilots to ground crews and management doesn’t have a stellar track record for managing those troubles without letting it affect customer service. 

A Political Layover

The number of politicians with a vested interest makes merger talks more difficult.  While the U.S. government technically can’t block a merger outright, it can certainly make things more difficult. 

With U.S. House of Representatives Transportation Committee Chairman James Oberstar hailing from Northwest’s home state of Minnesota and the committee’s aviation subcommittee chairman U.S. Rep. Jerry Costello coming from Illinois [United's headquarters], things are bound to get interesting. Plus, Georgia’s congressmen are sure to be angling to ensure Delta will be maintaining a post-merger Atlanta hub.

If Air France-KLM helps to partially fund the merger, it will surely want a stake in the newly formed carrier. But U.S. government regulations limit a foreign firm’s ownership of a domestic airline to less than 25%, as illustrated by Lufthansa’s 19% purchase of JetBlue Airways Corp. (JBLU) just last month.

Airline industry regulations aren’t the only type of U.S. government oversight Air France-KLM has to worry about.  CNNMoney reported that the European carrier is applying to de-list its shares from the New York Stock Exchange effective Feb. 7. The stated reason was that 95% of trading occurs on the Euronext Paris, but Money Morning guru Martin Hutchinson thinks there is more at play.

"Given the U.S. legal system, it’s not surprising that foreign companies de-list, it’s more surprising that they haven’t all done so," he said.

The delisting of American Depositary Receipts (ADRs) by foreign companies is one of the worst consequences of the 2002 Sarbanes-Oxley Act. Section 404 of the Act is the most frequently cited problem, as it requires top managers to certify that the company’s computerized control systems are sound and resistant to hacking and can often lead to hiring an expensive outside consultant to ensure the systems are up to code. 

Since U.S. institutional investors can still purchase shares listed in London or Paris, foreign CEOs don’t see why they should go to the added expense, trouble and risk to list on the American exchanges.

Streamlining Costs

Air France-KLM’s might be looking to cut costs because Delta isn’t the only expensive merger on the European carrier’s agenda. The French/Netherlands pairing has been eyeing troubled European rival Alitalia – Linee Aeree Italiane S.p A. and has pledged to invest $1.09 billion (750 million euros) if selected as the buyer for the Italian government’s 49.9% share in the carrier.

While MarketWatch reports that the European airline had a sizeable $9.1 billion (6.2 billion euros) in cash reserves as of late September, it might not be enough to handle two major acquisitions at the same time.

Plus, while Air France-KLM has been selected as the preferred buyer of Alitalia, the deal is far from settled.  The Italian government was not pleased with Air France-KLM’s offer for its both its stake and convertible bonds.  The carrier is also running into regional pressure over Milan’s Malpensa airport.  In fact, the entire deal might be at risk if Air France-KLM does not eliminate planned route cuts from Malpensa, Forbes reported.

News and Related Story Links:

• Bloomberg:
  Air France Gains After Report It May Fund Delta-Northwest Deal

• MarketWatch:
  Air France-KLM plays cupid on the U.S. tarmac

• Reuters:
  Delta in merger talks with Northwest-congressman

• Forbes:
  Alitalia declines comment on reported Prodi demand for Malpensa change

• Money Morning:
  Lufthansa-JetBlue Deal Typifies Foreign-Investment Deals That Will Accelerate as Greenback Weakens

Last week’s tie-up between Germany’s Deutsche Lufthansa AG (DLAKY) and the U.S.-based JetBlue Airways Corp. (JBLU) is yet another example of the kind of foreign investment in prime U.S. assets we’ve told you to expect and that we see accelerating in 2008.

Sadly, many investors will fail to realize the significance of such transactions until it’s too late.

Thankfully, however, Money Morning readers are not part of that group.

So what’s the latest in the Lufthansa deal?

In a nutshell, Lufthansa – which happens to be my preferred airline when I head over to Europe – paid $300 million for a 19% stake in JetBlue, a faded Wall Street darling. As part of the deal, the German carrier also gets the right to name a new member to the JetBlue corporate board.

Ostensibly, the deal is about helping JetBlue manage fuel costs that it has so far left unhedged at a time when oil seems destined to eclipse the $100 a barrel mark.

However, there’s another angle and, as usual, it’s one that has been largely overlooked by the investing masses.

Lufthansa has essentially picked up one-fifth of JetBlue for 70 cents on the dollar, while taking advantage of a transaction that would have cost it more than $400 million when JetBlue was still a semblance of a hot property only three years ago.

Call it a weak dollar play or, depending on your perspective, a strong euro play. Either way, it underscores that Lufthansa is the latest in a long string of foreign entities to capitalize on a weakened greenback while potentially adding significantly to their own bottom line.

This may not be immediately clear but our guess is that Lufthansa would have purchased all of Jet Blue were it not for current U.S. law that limits the foreign-ownership of a U.S. flagged air carrier to less than 50%. That same regulation also imposes separate restrictions on foreign managers making operational decisions.

We also believe that Lufthansa’s acquisition really has very little to do with JetBlue’s fuel costs or liquidity. Instead, it seems likely that the deal is more in line with Lufthansa wanting another marketing partner to feed its profitable European routes.

In short, this deal provides yet another example of how foreign companies will capitalize on the weaker dollar.

Shrewd, acquisitive companies can pick up companies and other dollar-denominated assets today for pennies on every dollar that they would have had to spend in strong-dollar periods. In doing so now, these firms not only get a bargain, they also create crucial marketing relationships that will pay off in a big way when the U.S. dollar – and the U.S. economy – eventually recovers, as it will.

We expect this trend to continue in 2008 with one notable difference.

The companies acquired will no longer be secondary industries but will increasingly represent the crown jewels of U.S. industry, including many Fortune 100 names that are presently viewed as "untouchable" – either because management contends these firms are "not for sale," or because they’re viewed as too big to buy.

As the dollar declines further, both those obstacles will be swept away. With the dollar’s decline, the sticker prices of U.S. companies as measured by foreign currencies will actually decline. At the same time, sovereign wealth funds – including the so-called "Middle East Cash Barons" – will watch their coffers grow in size.

When the offers come, it will be the fiduciary responsibility of the managers of U.S. companies to listen. It may not be a matter of whether a company gets sold, but instead will be a decision about whom the company gets sold to – and at what price.

Naturally, this development will raise all sorts of concerns about national security and U.S. economic stability, and there’s likely to be a lot of hand wringing from our elected leaders – and from self-appointed civic leaders who don’t understand the new realities of global finance.

And much of it will be moot.

With the moves he’s made – and some he hasn’t, but should have – U.S. Federal Reserve Chairman Ben S. Bernanke has let the cat out of the bag and it’s going to be hell to put him back in.

We’ll continue to watch this unfold, to update you on what we see, and to look for ways to capitalize on new developments.

News and Related Story Links:

• MarketWatch.com:
  JetBlue says Lufthansa to Take 19% Stake.

• Money Morning Special Research Report:
  Nine Ways to Profit From the Diving Dollar.

• Money Morning Investment Analysis:
  Sovereign Wealth Funds Biting into the World’s Biggest Companies…Transparency and Motives in Question.

• Lufthansa.com:
  Corporate News Releases.