When British Airways and Iberia formed the International Airlines Group (IAG) with their merger early last year, the idea was to make both airlines stronger. But the IAG example shows that mergers don't help if flaws in the underlying business model are not addressed properly.

IAG finds itself in an awkward position. While British Airways is performing reasonably well under the current circumstances, Iberia is turning into a serious problem that has so far been underestimated and that does not seem prone to quick or easy solutions.

CEO Willie Walsh says that a “much broader and deeper restructuring” of Iberia is needed. The changes will be based on “a fundamental review of every aspect of the business.” That review is likely to lead to further downsizing and a reshaped network. The results are to be presented by the end of September, illustrating the urgency of the matter. Because of Iberia's troubles, IAG no longer expects to reach a breakeven result in 2012, but rather anticipates a “small operating loss.”

While British Airways managed to eke out a £12 million ($18.7 million) profit in the first half of 2012, Iberia posted a €263 million ($323 million) loss, almost twice as much as a year earlier. And as BA grew capacity (5.9%) and traffic (9.1%), demand for Iberia's services was down 3.6%.

What must be extremely worrying to IAG is that Walsh says that Iberia's long-haul routes, which historically have cross-subsidized the money-losing short- and medium-haul operations, are also part of the problem. “The long-haul cost base is unacceptable and completely out of line with the market,” Walsh concedes. “The historical levels of profitability are not sufficient.”

Iberia's long-haul network to Latin America is its core business. No other airline has a network between Europe and Latin America nearly as extensive. The entire Madrid hub is organized to feed European traffic onto the long-haul services. Iberia has limited exposure to North America, even more limited services to Africa and does not serve Asia with its own aircraft.

The focus on a single market segment is risky even conceptually, but market changes kick in as well. As Air France-KLM and Lufthansa restructure and shift capacity from other markets, they are rediscovering Latin America, a region with strong economic growth and rising demand for air travel. There, more serious competition is emerging through the creation of big airline groups such as Latam (LAN and TAM) and Avianca-TACA. While IAG's two airlines are members of the Oneworld alliance like LAN, they are also competing for the same passengers. And TAM has its own growth plans for Europe.

TAM, LAN and Avianca-TACA are also offering a superior onboard product, making additional investment in Iberia's service levels necessary.

The long-haul woes are compounded by the ongoing problem of not being able to operate short-haul profitably, because costs are too high and the Spanish market has become weaker with the local economy suffering.

Walsh says that Iberia is “chronically uncompetitive against the low-cost carriers,” which long ago made Spain their most important destination.

One move to limit short-haul losses was the introduction of Iberia Express, an affiliate with lower labor costs and significantly higher productivity. But now serious doubts are emerging as to whether Iberia Express can continue to expand as planned.

The airline launched three months ago and has been an operational success so far. It currently flies 10 former Iberia Airbus A320s and reached a unit cost improvement of 30% compared to its parent, 10 points higher than forecast. Another four aircraft are to be added next year as the Express unit has already been profitable in June. “Iberia Express and Vueling (the group's low-cost affiliate) show that it is possible to make money in Spain,” Walsh notes.

However, Iberia may no longer be able to use Express as a cost-savings tool. The airline and its unions have been in arbitration over pay and work rules and the ruling—unpublished—is “unclear and difficult to implement,” Walsh says. If it is not changed, it could effectively lead to a cap on Iberia Express' cost-competitiveness, limiting the carrier to only 14 aircraft. Iberia wanted Express to grow to 40 aircraft and provide a substantial part of its European service by the end of 2015. Those plans now hang in the balance until at least October, when a court is scheduled to resolve the case. Walsh already indicates that while Iberia Express was the preferred option to address short-haul losses, IAG has alternatives. Iberia could outsource part of its network to an operator in which it lacks majority ownership, industry sources say.

Meanwhile, integration of BMI into British Airways is going smoothly. Eight of BMI's 25 aircraft have been taken on the BA air operator's certificate (AOC) and have been rebranded, and 87 pilots and 125 cabin crew have transitioned. BA will not continue to operate BMI's two remaining Airbus A330-200s. It has also decided to shut down low-fare affiliate BMIbaby on Sept. 9.

Iberia may be one of the most difficult restructuring cases among Western European airlines, but it is not unique. While even market leaders Air France-KLM and Lufthansa are in strategic trouble, smaller yet relatively large independent carriers such as SAS Group's Scandinavian Airlines are even more exposed. SAS is suffering because the overwhelming majority of its business is short-haul—and no European legacy carrier makes money on short-haul these days.

SAS has gone through several restructuring programs and leadership changes, with industry novice Rickard Gustafson at the helm since last year. But neither Gustafson nor his predecessors have managed to stop the airline's downhill slide. For the moment, he is responding with more staff cuts. Gustafson says that “delivering productivity gains and cost savings will create redundancies that must be taken out.” The airline is already eliminating around 300 administrative positions and has cut thousands of jobs over the past several years. SAS has not made a profit since 2007.

Gustafson has also launched the 4Excellence program that is aimed at returning the airline to profitability. Unit costs are to improve by 3-5% annually and SAS reached 4% in the first half of this year. However, that is excluding the significant rise in fuel costs. With fuel included, the revenue/cost gap is actually widening and no end of that dangerous trend is in sight. Gustafson also admits that SAS cannot raise fares to compensate for higher costs given intense competition, notably from low-fare rival Norwegian, which continues its strong growth in the Scandinavian market. The uncertainties are so great that Gustafson does not even want to give financial guidance for the full year.

Air Berlin is another of Europe's desperate carriers. The airline was saved late last year by Etihad Airways, which bought a 29.2% stake and became its single largest shareholder. More importantly, Etihad provided $255 million in financing over a five-year period. Only six months later, Air Berlin has drawn on almost the entire credit facility. The carrier admitted that it had used up a €169.2 million Etihad loan by June 30.

The statement illustrates how serious its financial woes have been and how serious they remain. Air Berlin's second-quarter loss widened, reaching €66.2 million, compared to €43 million a year earlier. Sales rose 1.7%, but costs were up 2.5%. CEO Hartmut Mehdorn nevertheless claims the airline is on track to make a profit next year.