UPDATE 3-British Airways owner IAG to buy UK's bmi
* IAG, Lufthansa reach agreement in principle for bmi sale
* IAG expects deal to be complete in Q1 2012
* IAG Q3 operating profit 363 mln euros vs 528 mln euros
* Premium traffic growth slows in October
* IAG shares down 3 pct
LONDON, Nov 4 (Reuters) - British Airways owner IAG has agreed to buy Lufthansa's UK unit bmi in a bid to squeeze more growth from its capacity constrained Heathrow hub and expand services to emerging markets in Asia and Latin America.
The agreement came as IAG reported a sharp fall in third-quarter profit, hit by higher fuel costs, highlighting the need for airlines to seek growth where they can.
BA and Iberia parent IAG on Friday said it had reached an agreement in principle with Lufthansa for the sale of loss-making bmi with a deal likely to be completed in the first quarter of 2012, subject to due diligence and regulatory clearances.
With 9 percent of the take-off and landing slots, bmi is the second-largest carrier at Heathrow, Europe's busiest airport. Buying bmi offers IAG the opportunity to grow at Heathrow, which is operating at full capacity after plans to build a third runway were scrapped.
"It is clear that bmi in its current form is unsustainable but we're confident we can make a success of it," IAG's Chief Executive Willie Walsh told reporters.
"We will particularly look to expand BA's long-haul network ... it will allow us to connect Heathrow and the UK to emerging markets, particularly in Asia and Latin America."
Bmi comprises three underperforming businesses: a carrier serving Europe, the Middle East and Africa; bmi regional, serving the UK; and low-cost unit bmibaby.
Analysts believe the IAG deal, which is for the main carrier and bmibaby, would be worth around 300 million pounds ($479 million). The regional unit will likely be sold to a UK investor group.
Walsh, who would not disclose any financial details, added that IAG did not yet have exclusivity on a deal but said IAG's offer was more attractive than others Lufthansa had received.
Rival UK carrier Virgin Atlantic said it had also made a bid for bmi and was still "working with Lufthansa". Reuters on Thursday reported a deal between IAG and Lufthansa over bmi was imminent.
IAG shares were down 3 percent at 164 pence by 1045 GMT, valuing the business at around 2 billion pounds.
"If the deal goes through, it will be a long term strategic positive for IAG if they can build up further market share at Heathrow," said Davy Stockbrokers analyst Stephen Furlong.
"In terms of the results, they are disappointing in that you see the fuel costs are not being offset by revenue."
A Lufthansa spokesman said he was "confident the planned transaction (with IAG) will be successful" because IAG had offered "the most attractive prospect for the future of bmi".
IAG's BA is the largest carrier at Heathrow with a 43.1 percent share of the slots -- ahead of Virgin in fifth place with 3.1 percent.
Walsh said he was confident the bmi deal would be cleared by regulators because IAG's holding at Heathrow is small compared with rivals at other European hubs -- Lufthansa holds two-thirds of the slots at Frankfurt, while Air France-KLM has 59 percent at Charles de Gaulle in Paris and 57 percent at Amsterdam's Schiphol.
"Regulatory rules are not set by (Virgin Atlantic founder Richard) Branson -- they are set by competent authorities," said Walsh.
IAG, Europe's second-biggest airline group by value behind Lufthansa, said operating profit in the three months to the end of September fell to 363 million euros ($499 million) from last year's 528 million euros. It was just ahead of the 350 million euros analysts had expected.
IAG's fuel bill rose by a quarter to 1.39 billion euros in the period and weak demand at Spain's Iberia offset strong trade at British Airways.
It expects to report a full-year operating profit of roughly double the 225 million euros in reported in 2010. It is expected to post an average operating profit of 562 million euros for 2011, according to a Thomson Reuters poll.
IAG's European rivals have found it more difficult to overcome high oil prices and sluggish demand.
Lufthansa last week reported results battered by high fuel costs and slashed plans to expand capacity next year, while Air France-KLM has refused to comment on reports that the company is poised to issue a "significant profit warning" next week.
"Rising fuel costs are the biggest challenge to the industry in the short term along with potentially weaker demand in 2012," said Walsh, adding that growth in first and business class traffic, the most profitable part of its business, slowed in October.