The LSE Summer School 2004 Management Programme Organisation and Strategic Management

The LSE Summer School 2004 – Management Programme – Organisation and Strategic Management

Class Teacher: Niels-Erik Wergin

Air France/KLM Merger: Perilous Flight Ahead
Betting that bigger is better, Air France and KLM Royal Dutch Airlines announced their intention to merge into Europe’s largest air carrier last week.
The new airline would combine Europe’s number one and number seven carriers in terms of passengers, creating an airline that would be the sixth-biggest in the world (after five U.S. carriers). But the merger is fraught with peril for both shareholders and travelers, say Wharton professors and others. If done right, it could create an efficient organization with lower costs, but without the power to charge monopoly fares. If managers or regulators slip, however, the result could be both higher fares and higher costs.
“Unless you can show me these phenomenal economies of scale, I will assume that when airlines get together they are going to use their power to benefit themselves, not consumers,” says Bruce Allen, a Wharton professor of business and public policy. “If I am a shareholder I’ll say, ‘Hey, earning monopoly fares is good stuff,’ but if I’m a consumer I worry about fewer choices – and higher fares with those fewer choices.”
Pending approval by shareholders, labor unions and regulators, the merger would take effect sometime around April 2004, according to KLM spokesman Bart Kloster.

It’s Not the Size That Counts …

Why merge? Air France/KLM, like many companies involved in big mergers, is talking out of both sides of its mouth on this one.
On one hand, says Kloster, the merger will result in massive operating efficiencies as the two carriers streamline duplicate operations and cut duplicate routes. The company promises $706.4 million (€600 million) of long-term cost savings and revenue increases, according to documents cited in an analysis by Credit Suisse First Boston. (The CSFB analysis proclaims only a 30% chance the airline will achieve that goal.)
“We are going to coordinate schedules, fares, frequent flier programs, lounge access, cargo operations and revenue management. We are adjusting networks, schedules, joint product development, joint purchasing, joint staff training – everything you can do jointly we will do jointly,” Kloster says.
On the other hand, somehow, the airlines are going to do this with “limited” redundancies and without raising air fares. “We can reduce costs by combining certain operations in one aircraft where two operate now, and those reduced costs will lead to lower fares,” Kloster says.
Consumer Beware
Naturally, consumer advocates are wary that ‘efficiencies’ mean raising fares, consolidating routes and reducing choices. “To the extent that people claim there are consumer welfares created by large airline mergers, there have never been any,” says independent airline analyst Bob Mann.
For his part, Allen isn’t so sure bigger is better. He points out that the most profitable carriers right now are all small-to-medium-sized operations like JetBlue and Frontier. Profitable Southwest, meanwhile, may be America’s largest domestic carrier, but it doesn’t deal with any international routes and doesn’t operate major hubs.
“The interesting thing right now is that the successful carriers are the little guys," he says, adding that the success of small airlines throws into doubt the benefit of economies of scale. "The low costs seem to be if you’re not that big, and if you’re not focused on a hub-and-spoke system. Is this a transitory thing? I don’t think Southwest’s low costs are transitory.”
Meanwhile, according to a report yesterday in the New York Times, the Mesa Air Group, based in Phoenix, has offered to buy Atlantic Coast Airlines for $512 million in stock. If the deal goes through, it would create the largest regional airline in the U.S. Atlantic Coast currently runs flights for United and Delta, while Mesa operates regional flights for United and America West, according to the Times.
The pressures on European airlines are slightly different than the pressures on U.S. airlines, giving the big national carriers a bit more leverage with business travelers, says James Fremantle of the Air Transport Users’ Council, a passenger watchdog in the UK. While airlines like JetBlue, Frontier and Southwest are now cutting deeply into key business routes like New York-LA and LA-San Francisco, Europe’s low fare carriers are often exiled to inconvenient secondary airports. Ryanair, Europe’s largest low-fare carrier, flies into airports that are long drives from London, Paris, Brussels and Frankfurt, greatly limiting its appeal to business travelers. That puts the new AF/KLM in a stronger position against Ryanair than American airlines are against Southwest.
“Ryanair doesn’t really compete with many other airlines,” he says.
On the other hand, European airlines also must compete with a functioning rail system – including, for instance, the Eurostar train, which recently cut its trip time from central London to central Paris to 2 hours and 40 minutes.
In any competitive environment, mergers are difficult operations to pull off, says Wharton management professor Peter Cappelli, director of the school’s Center for Human Resources. He agrees with an October 2002 BusinessWeek analysis that studied 302 major mergers between 1995 and 2001, and found that 61% of buyers destroyed their own shareholders’ wealth while overpaying shareholders of the smaller firms they were snapping up.
“The learning curve is steep in figuring out how to do mergers, so the companies that do them well are the ones that do a lot of them” rather than just expanding with one big merger, Cappelli says.

A Sweet Ride for Shareholders

Part of the puzzle of the KLM/Air France merger is the bizarre corporate structure it will create.

The treaties that allow airlines to fly between countries are currently negotiated on a nation-by-nation basis. So if Air France bought KLM outright, the airlines would have to choose whether to fly the routes guaranteed to the French or to the Dutch. Meanwhile, prickly politicians in both nations are more than a little concerned about “foreign control” of a national flagship carrier.
So KLM and Air France will be operated as separate units by a new holding company, which will be 81% owned by Air France shareholders and 19% by KLM shareholders. The new company will maintain Air France’s stock exchange listing, and AF shares will transfer over to the new company on a 1-for-1 basis. KLM will join the Skyteam airline alliance, allowing the two separately-run subsidiaries to coordinate schedules and share ticketing.
Skyteam is one of the three major airline alliances. Airline alliances agree to some level of cooperation between their members when it comes to organizing schedules, ticketing and frequent flier programs. The two biggest are Star Alliance, led by United and Lufthansa, and OneWorld, led by American Airlines and British Airways. Skyteam, with Delta and Air France, has up until now been the third player. KLM, Northwest and Continental are all outside the three alliances, but now it looks like all three will join Skyteam, making it a much more powerful force.
KLM shareholders, meanwhile, will get a pretty sweet deal: 11 shares in the new company for 10 of their existing KLM shares, plus warrants to buy six and two-thirds more shares at a strike price of $23.5 (€20) any time during the next three and a half years. They’ll essentially receive a 40% premium on their KLM stock, and the deal promises an injection of $706.4 million (€600 million) of new capital into the firm.
But now things get weird. For three years, an additional class of voting, but noneconomic stock will be created and split between the Dutch government and two Dutch foundations, which together will have 51% of the voting rights over the KLM subsidiary (but not Air France or the holding company.)
Why does this expire in three years? The EU is already starting to negotiate air travel treaties that would cover the entire 15-nation union rather than work on a country-by-country basis. New treaties would make the need for partial Dutch control obsolete.
For five years, the new company offers KLM stockholders “assurances” that the two brands will remain separate and intact. And for eight years, the company guarantees to the Dutch government that the Paris and Amsterdam air hubs will be treated as a dual-hub system in a “fair” manner.
The merger wouldn’t affect KLM’s existing joint venture with Northwest Airlines for selling transatlantic flights, nor would it affect Air France’s cooperation with Delta. In fact, the two operating units would compete on transatlantic flights, according to Kloster. That’s certainly possible, Wharton professors say, though of course the merged company would make more money if the units cooperated rather than competed. Northwest hasn’t been asked to join Skyteam, though they would certainly be open to an invitation, according to Northwest spokesman Bill Mellon.
Only Air France and KLM executives know whether this chimeric corporate structure is a legal ruse or a potential operational pitfall. The difference is key to the success of this merger, says Wharton management professor Robert E. Mittelstaedt.
“The real issue is whether the complexity will be played out operationally or whether it is simply an organizational structuring issue from a legal standpoint,” he says. “If it becomes more complex operationally they are going to have difficulty achieving what they want to out of the merger, which is operational efficiency and increased marketing clout.”
To achieve competitive advantage, the company “has to simplify structures, not make them more complex,” he says.

The First of Many

A flurry of announcements has followed the AF/KLM merger. First, Alitalia executives said they wanted to join the AF/KLM system, which would turn the chimera into a hydra. Alitalia, Italy’s national carrier, which has shaky finances but owns 2% of Air France, has already joined a cargo shipping joint venture with Air France, Delta and Korean Air.
Then British Airways admitted it has been looking hungrily at Iberia, Spain’s national carrier. Swiss International Airlines, the financially pained Swiss national carrier, aligned itself with American Airlines and BA’s OneWorld partnership as rumors swirled that Lufthansa was interested in snapping it up.
The consolidation of Europe’s airlines is inevitable, Wharton professors suggest. The consolidation of the national flight treaties into EU-wide treaties eliminates the major barrier to cross-border mergers, and struggling airlines are looking at economies of scale as a way to survive.
“The number of airlines and the structure of airlines in Europe only exists the way it does because of government regulation,” Cappelli says. “In the future, you might see a couple of big ones and more small ones. You wouldn’t see the distribution you have now – a dozen midsized carriers.”
Mittelstaedt agrees. In a tough economic environment, markets will consolidate until something stops them. “In both Europe and the U.S.,” he notes, “you are going to see mergers until the regulators get nervous about the minimum number of airlines you can have and still maintain some aspect of competitive markets.”
Source: Knowledge@Wharton newsletter, Wharton Business School, 22/10/2003
AT&T Wireless: Will Cingular's Big Bet Pay Off?
Last week Cingular, the second-largest wireless telephone firm in the U.S., beat Britain's Vodafone in a battle for AT&T Wireless with a $41 billion bid. If regulators approve, the merger will create the country's largest wireless telephone company. But will Cingular be able to build real value from the deal? Professors at Wharton and other experts give the proposed merger a thumbs-up in terms of strategy. But they also warn that it is too early to tell whether Cingular’s $41 billion, $15 per share cash offer will prove to be a good investment - in part because the whole wireless telephony industry is in flux.
Gerald Faulhaber, a professor of public policy and former chief economist for the Federal Communications Commission, says that industry insiders have been predicting wireless industry consolidation for some time. “The reason these companies are having trouble making money is because the competition is pretty tough,” he says.
Faulhaber notes that the merger accomplishes several things for Cingular. For starters, it reduces the number of players in the wireless industry from six to five. It takes out AT&T Wireless, which had been an aggressive price-cutting competitor in the past. And it vaults Cingular from third place to numero uno status as the largest cellular provider.
“This deal completes Cingular,” says Jeff Kagan, an independent telecom analyst inAtlanta. If the merger goes through, the company will grow by about 22 million subscribers to 46 million customers, besting Verizon Wireless, which currently has 37 million subscribers. In addition, the merger addresses issues that each company has faced: not enough spectrum, not enough capacity, dead spots, and busy circuits. “After the merger, the new company will have twice the spectrum, twice the capacity, twice the cell towers, and that should alleviate the problems,” he says.
Is the Price Right?
Relative to certain kinds of metrics, such as numbers of subscribers and earnings, the price Cingular is paying seems like a fairly hefty bid, says Robert Holthausen, a professor of accounting. But, he says, that doesn’t mean it’s not a smart thing to do. The economies of scale are so huge for wireless telephones that the industry probably can’t support many wireless competitors over the long term, he suggests.
The bidding war between Cingular and Vodafone over AT&T Wireless reportedly concluded in a late-night, $15 a share deal that had an unusual stipulation: The buyer had to sign within 60 seconds of seeing the contract. But is the result just what you’d expect from a good 60-second decision – maybe right in its general thrust, but a little loose in the particulars?
Harbir Singh, a professor of management who has done lots of research on mergers, is unsure. He read that the final price exceeded what the CEOs of SBC and BellSouth had originally approved (Cingular is jointly owned by the two regional companies). The only new piece of information they had, he says, is that Vodafone’s stock price went up on news that the company’s bid had not been accepted. Singh believes that'snot much to go on. “To me what matters is new information about the assets, not about the other bidders. There’s been no evidence they got new data about the assets on Tuesday and if they did, that they had enough time to correctly value the new data.
“I sincerely hope that Cingular has made careful calculations and has a well-developed plan for how to extract synergies because the company has been put in a position where it has paid a lot for this acquisition. Now things will have to go really well for Cingular before it can successfully generate value,” he adds.
Kagan sees two big challenges ahead for Cingular if the merger passes anti-trust muster. The first is integrating the company’s service networks. The second is improving customer service, which he says has been a challenge for both SBC and BellSouth. “If they can do that, I think they’ll be firing on all cylinders like Verizon is now and they’ll give Verizon a run for their money.” If that happens, there will be two huge national wireless companies, with Sprint “a distant third,” according to Kagan.
And will this game of musical chairs continue? Kagan and Wharton professors think so. But no one is sure whether the five companies will eventually be reduced to three. Kagan believes that regulatory approval is likely for this merger, but the chances of more transactions being approved will decline if the number of players shrinks. Three may be the breaking point, Kagan says. “I think that’s going to be sticky. There’s a fifty-fifty chance of that happening.”
Interestingly, Cingular’s biggest competitor approves of the merger. Verizon Communications’ CEO Ivan Seidenberg has spoken positively about the Cingular-AT&T Wireless deal. It’s not a typical reaction for a company that suddenly finds itself pulled out of its number one spot, but Faulhaber explains that Seidenberg has a good reason for his enthusiasm: “The reason is that people in the industry are hoping that we’ll get more consolidation, which will make it easier to obtain higher prices,” Faulhaber says.
While the Cingular-AT&T Wireless merger is a straight-forward consolidation play, Faulhaber adds, the future of the wireless sector as a whole is less clear. Although he downplays the difficulty of switching technologies – once the towers are all built, he asks, who cares what frequency they’re set to? – he is concerned about the relative infancy of theU.S.cellular industry in general. “The thing that stares you right in the face about wireless is how seriously behind the rest of the world we are, particularlyEast Asia. I don’t know of any other technology where we are a full generation behind, except this one. It shouldn’t be that way, but it is,” he says.
Now that the wireless industry is beginning to mature, Faulhaber says it faces a huge challenge ahead: Finding new opportunities for growth. While some see data as the opportunity of the future, he’s not so sure. “I’ve been very dubious about that strategy, but it’s clear that wireless companies need something that can take them beyond where they are now.”
In spite of the 17% stake thatJapan’s DoCoMo Wireless holds in AT&T Wireless, Faulhaber says that no one in theU.S.has yet figured out how to make data pay. Games, ring tones, hand-held Internet browsing? Faulhaber is skeptical whether there’s a great business model there. “It’s not clear to me exactly where everybody goes from here,” Faulhaber says. “I’m pretty sure that the business model of downloading ring tones is probably not a great long-term strategy.”
Source: Knowledge@Wharton newsletter, Wharton Business School, 25/02/2004

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