Air France, Air One bidding for Alitalia

Alitalia jets are seen on the tarmac of Malpensa airport in Milan October 22, 2007.

ROME/MILAN (Reuters) - Air France-KLM (AIRF.PA) said it would make an offer for loss-making Italian carrier Alitalia AZPIa.MI, a long-awaited move that faces a serious challenge only from tiny Italian airline Air One.

The winning bidder for Alitalia, which loses a million euros ($1.5 million) a day, will be taking on an airline beset with strike-prone unions, inefficiency and entrenched regional interests who back maintaining twin hubs in Rome and Milan.

Germany's Lufthansa (LHAG.DE) walked away from the sale of the Italian state's 49.9 percent holding at the last minute, saying on Thursday an offer could have put its investment-grade debt rating at risk.

"Air France-KLM are the most suited investor to take over Alitalia, more so than Lufthansa because they've gone through the process of merging two totally different airlines," said Diogenis Papiomytis, aviation consultant with Frost & Sullivan. "And they are the ones who will benefit the most from Alitalia."

A little-known group led by Italian lawyer Antonio Baldassarre also presented an offer, ANSA news agency reported, even though Alitalia had already excluded the group from the running for lack of financial muscle to pull off a deal.

That leaves Italy's fragile centre-left government with two vastly different options in Air One and Air France-KLM, each with problems of their own.

An Air One takeover would keep Alitalia in Italian hands but there has been doubt over whether the smaller airline has the wherewithal to turn around an airline with a long list of woes.

The Air France-KLM choice would make Alitalia part of the world's biggest airline by sales but at a sharp discount to its share price and with potentially unpalatable job cuts.

The Franco-Dutch airline's proposal will be well below Alitalia's market value of 1.1 billion euros, a source familiar with the matter said. Air France-KLM has emphasized it would not do a deal that would dent its profitability.

Alitalia also has about 1.2 billion euros of debt.

Shares in the Italian airline jumped more than 6 percent to a one-month high after Air France-KLM said it was sending a non-binding letter of interest to the company's board, before ending up 1 percent at 0.87 euros.

They had tumbled 9 percent in November on fears Alitalia would not attract anyone other than Air One and that the sale would be delayed to next year.

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Alitalia, whose board was meeting on Thursday evening, is expected to pick a bidder for exclusive talks in mid-December.

Air One said its offer proposed investing 4 billion euros in Alitalia, mainly to renew its ageing fleet. Under its plan, the airline would be able to maintain its dual hub strategy and aimed for a break-even result by 2009 and a profit the following year.

Air One is the only name left from an earlier failed attempt to auction Alitalia. It is backed by top banks Intesa Sanpaolo (ISP.MI), Morgan Stanley, Nomura and Goldman Sachs.

In contrast to Air One, Air France-KLM said it aimed to develop a business plan in line with Alitalia's latest "survival" plan unveiled in August that would scale back the airline's presence at Milan and focus on its Rome hub.

It said it would be "counting on the support of the Italian carrier's entire workforce". Alitalia is infamous for its strong labor unions that have staged crippling strikes to thwart management efforts to cut jobs.

Air France said an Alitalia bid would meet requirements for its economic and financial stability, but added it continued to also weigh an offer for Spain's Iberia (IBLA.MC).

Air France has been tipped as a suitor for Alitalia since a marketing agreement struck in 2001 and a share-swap deal the following year. But it played down talk of a bid over the past year, saying Alitalia should first sort out its myriad problems.

Italian Prime Minister Romano Prodi has said Alitalia should go to the best bidder, with Italian ownership a secondary issue.

Lufthansa shares were up less than 1 percent at 18.28 euros, reversing losses after it decided against bidding for Alitalia.

Shares in Air France-KLM were up 2.4 percent at 23.81 euros after touching 24.65 earlier in the session.

Lazard Ltd (LAZ.N) is advising Air France-KLM.

(Additional reporting by Dominique Vidalon in Paris, Jo Winterbottom in Milan, Andres Moeser in Frankfurt, Mathieu Robbins in London and Alberto Sisto in Rome; Editing by Quentin Bryar)