Lufthansa, the German flag carrier, is in advanced negotiations with Swiss International Air Lines, which could lead to an eventual takeover of the loss-making Swiss carrier.
A deal would be a significant further step in the consolidation of the fragmented European airline industry following last year's takeover of KLM, the Dutch flag carrier by Air France.
Lufthansa tried nearly two years ago to take a stake in Swiss, but was thwarted, when Swiss chose instead a rival offer from British Airways to enter a commercial alliance including membership of the BA-led Oneworld airline grouping.
The BA-Swiss deal foundered last year, however, which left the Swiss carrier outside any of the three global airline alliances, Star, Oneworld and SkyTeam, and vulnerable to a further takeover approach by Lufthansa.
Swiss, which was created in 2002 out of the collapse and liquidation of Swissair, the former Swiss flag carrier, has remained loss-making.
Before a deal with Lufthansa can be completed the two airlines must find a structure that will not jeopardize Swiss's international traffic rights.
Swiss is also expected to seek to maintain its brand and some degree of operating independence, while also preserving some direct long-haul connections from its main Zürich hub.
Chris Avery, aviation analyst at JP Morgan, said "in its current size and condition, it is difficult to see shareholder value in an acquisition (of Swiss). There is significant restructuring to be paid for to downsize it and integrate it with Lufthansa's Munich hub."
Christoph Franz, chief executive of Swiss and a former Lufthansa manager, declined to comment on the takeover speculation at the group's annual results news conference on Friday Lufthansa also refused to comment.
Sources close to Swiss said national political resistance to a deal with Lufthansa -- a decisive hindrance in earlier negotiations -- had declined significantly. Switzerland's federal government and cantons own 32.5 percent of the airline.
While many politicians remained emotionally attached to independence, resistance had softened following other airline alliances and better understanding of the challenges facing Swiss.
Following last year's collapse of the alliance talks with BA, politicians also appreciate Lufthansa is the only alternative.
The group's dominant private sector shareholders, led by UBS and Credit Suisse, are believed to be prepared to consider any commercially viable transaction.
The timing of any announcement could be influenced by the need to appoint a successor to Pieter Bouw, chairman of Swiss, who is stepping down.
A candidate must be named by the end of April, in time for the group's shareholders' meeting the following month. The choice could be linked to a reorientation in the company's future status or strategy.
Swiss confirmed on Friday it lost 140 million Swiss francs last year after hopes for breakeven were thrown off course by higher fuel prices. Franz said achieving profitability this year would depend on securing further cost cuts from employees and suppliers.
Swiss is in talks with most of its eight unions on concessions, ranging from revising existing collective bargaining arrangements to significant job losses.
"We have made good progress", he said. The company, which has shed more than a third of its staff, wants to reduce costs by 300 million Swiss francs from 2007, largely through the loss of another 800-1,000 jobs.
Pilots from its regional fleet, facing the biggest cuts, have vehemently opposed the measures and called strike ballots. Last month, engineers at the company's Geneva base staging lightning stoppages in reaction to plans to reduce services.
Franz said trading conditions had improved this year, with better load factors on European and intercontinental routes and promising forward bookings for the crucial summer period.
However, he repeated that further savings from employees were essential for Swiss to have a viable future. "We are quite confident we will come to a reasonable solution. Everyone agrees that without competitive cost structures, survival in this industry is impossible", he said.