THE new Government faces some headaches in the semi state sector. But nowhere will the much vaunted partnership approach to doing business under which management and unions agree the way forward be tested more thoroughly than at Aer Lingus where, according to a report from NCB, early warning signs of a group in financial difficulty are beginning to appear".

The group is not in dire financial straits. Its 1996 results recorded solid pretax profits of £41 million, it is benefiting from the overall buoyancy in the airline industry and is budgeting for higher passenger numbers. But management itself has conceded for some time that change is essential; costs need to be cut and operating margins improved to prepare the airline for the next market downturn and give it enough cash to meet its investment needs, particularly in purchasing new aircraft. The question now is whether management and unions can sit down and agree on how to do this.

Like their counterparts elsewhere in the State sector, Aer Lingus' management and board face political as well as business constraints. Successive governments have expected the airline to act as job creator national flag carrier and the economic centre of North Dublin.

Now the airline finds itself stuck in the middle, in industry terms. It does not have the flexibility of the smaller airlines, such as Ryanair, which operates on lower cost bases and can thus compete aggressively with Aer Lingus. But neither is it a big airline, with a large variety of attractive routes and the associated economies of scale from its operations. So charting the future is not an easy task and will require a large degree of strategic thinking and not just a book keeping approach to holding costs down.

The fashionable answer to semi state problems is, of course, the strategic alliance. From the company's point of view, a partner buying an equity stake can offer cash to improve the balance sheet. From the Government's point of view it is a way to avoid putting up more cash - which, in any event, would be banned in the case of Aer Lingus under EU rules while avoiding the ugly "p" word privatisation. The Rainbow government asked management to report back on the options for such an alliance before the end of the year.

At the moment management and unions are both mulling on proposals put forward by arbitrator Phil Flynn, to award the bulk of staff represented by SIPTU - a 5.5 per cent pay increase, in return for entering negotiations on the necessary savings to secure the airline's future. A separate recommendation on the airline's pilots has already informally got the nod from management. It offers the airline some advantages, as it changes the basis on which the pilots are paid, while also addressing some of the key concerns of the pilots, particularly the pay of their junior members.

Tee issue of pilots' pay has been one of the triggers for the examination of the group's future. A Tribunal recommended a 17 per cent increase for the pilots. The NCB report warned that if this was generalised across the organisation, financial disaster would result. Mr Flynn, however, has altered the pilots offer and recommended a general 5.5 per cent increase for the rest of the staff, sweetening the package by back dating 2 per cent of this to last year.

However he recommends that payment of the increase be contingent on the unions entering discussions on a framework for a way forward for the airline, including savings. The precise scale of the required savings is not specified by Mr Flynn. But the Aer Lingus corporate plan, drawn up late last year and now being updated, says that savings amounting to around £42 inflation in five years time would be required. Add in around £6 million to £8 million for pay increases and it is clear that what would be under discussion is a repeat of the scale of savings £50 million - negotiated under the Cahill plan in 1993. Clearly these would have to come from all parts of the airline's operations and from payroll and non pay roll items. Apart from the scale of the savings, a key issue will be changing the culture of knock on pay claims in parts of the airline.

However the document drawn up by NCB Corporate Finance raises further questions. It suggests that the basis on which the corporate plan was drawn up look over optimistic. Inevitably the highly cyclical aviation sector will head into another downturn some time before the end of the five year plan. In addition, as shown by Ryanair's push into Continental Europe, competition continues to intensify.

Meanwhile NCB makes it clear that TEAM Aer Lingus, the aircraft maintenance subsidiary, faces a highly difficult marketplace. TEAM, which lost £5 million last year, aims to be in profit by 1999, but NCB believes that any risk to the plan for TEAM is on the downside." So TEAM, now inextricably bound legally and politically to Aer Lingus, remains a drain on the airline. The exact financial relationship between the group and TEAM remains unclear, although the parent insists that all dealings are on completely commercial grounds.

Aer Lingus has some strengths, as it starts examining its future and thinking about a strategic alliance. It has profitable transAtlantic routes although they are still partly protected by Government rules - an established brand image, valuable Heathrow landing slots, code sharing and other agreements. It can also forecast further passenger growth, based on the strength of the economy and - hopefully - a strategic alliance.

But it also faces major problems. NCB points to a relatively small home traffic base, low profit margins on many routes, a high cost based compared to its competition, "some unprofitable subsidiaries" and rising competition in many areas, including Heathrow.

Like many semi states, Aer Lingus faces the need to reinvent itself to face competition and the marketplace. The company's political masters face the challenge of allowing it do get on with the job, despite the inevitable fall out.