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European airline industry

I. Introduction

Given the current volatile nature of the European airline industry, analyst interest in this segment of the market is at its peak. The rising passenger numbers across Europe and increasing need for the consumer to have the choice of reasonable quality travel implies that consolidation in this sector is inevitable. Rising fuel costs, costs of operating and maintaining the aircrafts, ground staff, crew etc. have further strengthened the need for mergers within the sector. It is in this context that this paper attempts to study mergers and acquisitions within the airline sector in Europe.

European air travel tends to be short haul though there are some long distance routes within the continent. The rise of cheap budget airlines has accentuated a price war of huge proportions within this sector. Failing margins have been further eroded by the rise in operating costs. In a scenario of this kind, economies of scale and scope become vital for success. Growing organically often consumes considerable time and resource. It also reduces the ability to compete quickly and effectively especially in a volatile market. Therefore airlines across the globe have often found M&A to be an effective substitute for organic growth. History shows that both in the US and other parts of the world successful long haul carriers have often grown and widened their service/ coverage through acquiring smaller airline companies. It is natural therefore to expect that Europe will not be an exception to this trend.

The European airline industry is unique in several ways. It was to a large extent one of the early pioneers in the aviation industry globally. It has always faced competition from rail and road transport that have a much longer history in the continent.

This paper will analyse the economic motives/ factors underlying M&A in the European airline sector. Applying standard economic argumentation the paper seeks to justify the trends within the sector and rationalize their occurrence. In order to achieve this, the paper focuses on the decade of the 90's and the 2000's.

The paper is divided into four different sections. Section 1 is the literature review which examines the current understanding within the economic community of the airline sector and mergers and acquisitions in this sector. The main objective of this section is to collate all the secondary literature on mergers and acquisitions in the European airline industry. The main themes within this sector are identified and cross- referenced. The overall objective is to obtain a comprehensive, well-researched understanding of academic/ practitioner/ industry expert current perspective on M&A in the European airline industry. This, not only enables a complete understanding of the current state of the art in European airline M&A but also helps to provide the context for the analysis that follows in the next section.

Section 2 of the paper discusses the research methods used in the paper and examines the justifications for the same. Given the mixed (both quantitative and qualitative) nature of the research, the various methods of primary and secondary qualitative research are identified and the appropriate mix of techniques is explained at length. The methods section also outlines some of the major limitations of the techniques to be used in the dissertation. Validation and triangulation techniques are illustrated within the section. The paper uses standard strategic models such as the five forces framework to analyse the economic factors underlying M&A in the European airline industry. As a consequence, in the methods section, these models are described and the reasons for their use outlined. The paper also uses primary research in order to substantiate and corroborate the findings in the secondary literature. This section describes some of the main primary research techniques such as questionnaires, semi-structured interviews etc. It presents the justification for the use of an appropriate mix of these techniques within the dissertation.

Section 3 of the paper analyses the main findings from the secondary and primary literature. It develops a thematic analysis of the research question and examines the truth of various arguments. Naturally, it moves between various earlier sections to substantiate themes. The analysis follows two broad approaches. Arguments and counter arguments are identified and the strength of each is examined at some length. The primary research is used as a tool to help strengthen the results. Theoretical models are applied within the European airline industry context and relevant conclusions are drawn. Given the analytical nature of the research question, the section relies on an approach that describes and evaluates various themes found in the literature. At every point the paper attempts to keep a balance and present the multiple aspects of the issues at hand. Any major contradictions within the data are highlighted analysed.

Section 4 of the paper presents the main results and conclusions of the research. Given the exploratory nature of this effort, conclusions will have to be moderated and presented carefully. Once again the paper highlights controversial issues and does not attempt to force any one perspective. The implications of the results for stakeholders for the European airline industry are also examined at some length. Answers to questions such, as "how will the consumer benefit?" "What will be the implication for efficient regulation?" " How does this change the rules of the game of competition within the sector?" will be attempted in this section. Finally the paper attempts a modest set of recommendations for industry participants.

II. Literature review

The main arguments for mergers generally stem from various impacts that they have on costs faced by the firms and their market power. Sudarsanam (2003) argues that due to mergers costs may be reduced or market power augmented allowing firms to enjoy higher profits than under competitive conditions. Therefore one of the main arguments underlying mergers is that it allows firms to gain competitive advantage. Growth is another fundamental motive for mergers and acquisitions as pointed out by Gaughan (2002). Given the two alternatives of internal growth versus external growth, often the former is unacceptable because windows of opportunity within the market may be open for a limited period of time and organic growth could be slow.

Another dominant argument favouring mergers is the operating and financial synergies that can be extracted through them. Authors like Gaughan (2002) and Jensen and Ruback (1983) underline the strength of this argument by suggesting that synergy allows the combined firm to have a positive net acquisition value (NAV).

NAV = [VAB - ( VA + VB )] - (P+E)[1]

There are two types of synergies mentioned in the literature namely operating and financial synergy. In turn operating synergy is of two types namely revenue enhancing and cost reducing synergy. Clemente and Greenspan (1998) define revenue enhancing synergy as "a newly created/ strengthened product that is formulated by the fusion of two distinct attributes of the merger partners and which generates immediate and/ or long term revenue growth." [2] There is some evidence that mergers in the airline industry in Europe are aimed at extracting revenue synergies[3] for the consumer such as combinable fares, joint frequent flyer programs and single management corporate contract system (Spinetta, 2006).

2.1 Economies of scale

The other type of operating synergy arises out of cost reduction possibilities. Economies of scale are one of the main sources of these cost reductions and are emphasised by Gaughan (2002). Such cost reductions allow a firm to gain competitive advantage. Besanko et al (2000) defines economy of scale as the cost reduction in producing a product that is obtained from increasing the scale of its production in a given period. The figure below shows how spreading overhead (fixed costs) over a larger volume of product reduces per unit cost.

There are several ways to achieve economies of scale and these include gains arising from specialisation of labour and management, more efficient use of capital equipment, spreading of marketing and advertising costs etc. Empirical research proves that M&A are often used to achieve operating economies. Authors such as Lichtenberg and Siegel (1987) detect improvements in the efficiency of plants when they change ownership. Other authors, such as Mester (1987) and Sudarsanam (2002) also emphasize how important ownership change is in reducing operating and maintenance costs.

2.2 Financial synergies

Financial synergies are another source of competitive advantage arising from mergers. Gaughan (2002) suggests that based on the extent to which financial synergy exists in corporate combinations, the cost of capital should be lowered. This argument is controversial but based on the logic that if an acquisition lowers the volatility of the cash flows of the resulting entity, the suppliers of capital should consider the firm less risky and therefore reduce their return expectations. Higgins and Schall (1975) explain this effect in terms of debt coinsurance that implies that bankruptcy risk associated with combinations of firms may be reduced due to the lower correlation between the income streams of either of them. It is to be noted that there is no general agreement on this result as pointed out by Gaughan (2002). For example Lewellen and Elgers/Clark cited in Gaughan (2002) find that debt related motives are not very relevant for non-conglomerate acquisitions. Another source of financial synergies is economies of scale in financing such as lower flotation and transaction costs (Levy and Sarnat, 1970). Other authors such as Barney (1991) Peteraf (1993) and Carey (2000) stress that financing issues are but a side benefit from M&A.

2.3 Diversification

Historically diversification has been another motive for M&A globally. During the 1960's as pointed out by Gaughan (2002) firms acquired companies in unrelated business sectors in order to reduce the risk of the overall business. Micheal Gort (1974) argues that one possible area of benefits of diversification is the coinsurance effect. As two firms may have imperfectly correlated earnings therefore when they combine their joint risk is lower. Hence these merged companies can raise money more cheaply then otherwise. However corporate finance theory does not accept this argument as stated by Gaughan (2002). Many authors argue that diversification is better achieved by investors themselves rather then by the company. There is large empirical evidence that diversification results in loss of firm value and is not a good motive for M&A (Elgers & Clark, 1980; Berger and Ofek, 1995).

2.4 Fixed cost

As production costs have a significant fixed component in the airline industry many authors argue that mergers can be critical to survival and success. Sudarsanam (2003) underlines that scale economies could exist in both fixed production/ non production costs such as marketing, selling, distribution, storage etc. The business press has often highlighted the potential for such cost reduction through articles such as Tagliabue (2003). However some authors also point to the limits of such efficiency gains. In fact once the firm passes the MES (minimum efficient scale) there may be little scope for scale economies due to organizational control problems and anti-trust regulations.

2.5 Economies of learning

Economies of learning could also significantly enhance competitive advantage especially in an industry like airlines. Learning economies involve improving efficiency of operations through learning and training staff/ managers. It is self evident that the consensus in the literature is that a bigger firm will be better able to extract economies of learning[4]. Several prominent CEO's like Spinetta and van Wijk (2005) publicly acknowledge that learning is extremely important in the airline industry especially due to aggressive cost cutting by low cost carriers (LCC) such as Ryanair. In particular they agree that much of the benefits due to increased competition have been the learning that flagship carriers like air France have obtained from LCCs.

2.6 Horizontal mergers

One strand in the literature argues that in mature industries like airlines, low growth in demand, technological advances, deregulation/ increased competition, and pressure to reduce costs drives companies to seek horizontal mergers. In particular the dismantling of regulatory barriers and the creation of a single market have driven cross-border mergers in the European airline industry. Further the literature clearly points to the rising competition from Middle/ Far-Eastern airlines as one prime motivator of airline mergers in Europe. (Spintta, van Wijk, 2005)

As argued by Edghill (2007) horizontal mergers are economically justified by the stage in the product life cycle. Figure below shows how the dwindling profits in a maturing industry force incumbents to seek horizontal mergers so that they can spread fixed costs over larger volumes and protect margins. Economic theory argues that horizontal integration increases market power of the combined entity. Given that the three sources of market power are product differentiation, barriers to entry and market share (Lerner cited in Gaughan, 2002), horizontal mergers enable a firm to increase market share and therefore enhance market power. Therefore this represents another potent argument for horizontal M&A. There is considerable discussion in the literature about whether or not firms merge to enjoy increases in market power. Authors like Eckbo (1992) and Stillman (1983) argue against this contention where as others like Kim and Singal (1993) fiend evidence for it especially in the airline industry. With horizontal integration comes larger marker share. This enables the firm to improve its negotiating ability with suppliers and distributors, erect greater barriers to entry and lower its unit costs. This explains why even large firms are often on the look out for buying other firms within the industry. It should be noted that industries that have reached maturity in their life cycle tend to implement horizontal mergers more often. This is because such industries exhibit low growth in demand, and the pressure to reduce costs. (Edghill, 2007) Through acquisitions within such a maturing industry, a company is able to expand its consumer base quickly and at relatively low cost.

Empirically within Europe authors such as Friesen (2005) have studied high profile mergers like Air France- KLM and underlined that the merger - for- market power hypothesis does not hold. This author also cites earlier empirical evidence such as Knapp (1990) and Slovin et.al (1991) who find support for the market power hypothesis in the airline market. Other authors like Brueckner (2004) find that European Airline mergers have benefited the carriers themselves in terms of higher profits but have harmed consumers by reducing competition and social surplus.

In the airline industry there is considerable evidence that horizontal mergers are the dominant trend as pointed out in several press releases, such as August 2007 Traffic. (2007). The prime motivation for such horizontal mergers seems to be the maturing airline industry and the need to sustain operating margins[5]. In Europe analysts have often pointed out to the fragmented nature of the airline market that begs for consolidation (Businessweek, 2003). The Economist (2007) reports that the open skies policies agreed between America and EU should further consolidate an industry that has too many carriers.

2.7 Vertical mergers

Another strand in the literature argues that M&A is driven by transaction cost economies and vertical integration. The make or buy decision is at the heart of this argument as pointed out by Williamson (1975) who characterizes this as a hierarchy versus market decision. A vertically integrating merger transforms the relationship between a firm and its supplier from a market mediated to a hierarchical relationship. Firms choose one or the other alternative based on the comparative transactional costs of dealing with the market and internal organisation. Gaughan (2002) suggests that vertical integration itself could be driven by factors as varied as the need for a dependable source of supply[6], lower transaction costs (Carlton and Perloff, 1994), specialised inputs etc. There is considerable empirical evidence that vertical integration is a powerful motive for mergers as shown in the automobile industry, the steel aluminium canning industry etc.(Wall Street Journal 1989) For the airline business taking a stake in oil refining or travel agent business would qualify as a vertical merger. There is little evidence of any activity along these lines in the airline industry.

Richard Roll (1986) argues that the pride of managers in the acquiring firm plays a central role in some takeovers. This is known as the hubris hypothesis of takeovers. In fact he suggests that managers might overpay for the target firm because they wish to prove a point. According to the author, managers often superimpose their own valuation over that of an objectively determined market valuation. Therefore he argues that acquiring firm prices should fall while target firm prices should rise post acquisition. The combined effect of these should result in a negative loss in value due to the acquisition. Dodd (1980) finds statistical evidence of negative returns to the acquirer following the announcement of the planned takeover. Similarly Bradley et al (1983) fiend evidence that target firm shareholders achieve abnormal returns due to the bidding wars of M&A. Finally research conducted by Malatesta (1983) finds that the combined effects are neither positive nor negative. Recent evidence such as Hayward and Hambrick (1995) support the Hubris hypothesis by underlining how the premiums paid for deals is positively associated with the CEO's media praise and compensation.

2.8 Porter's 5 Forces

Porter's 5 forces model (1985) provides another economic rationale for mergers and acquisitions. The model itself is a static industry analysis that identifies the key forces affecting the profitability of any given industry. These forces are shown in the figure below.

Each of the forces has a significant impact upon profitability within the industry, motives for M&A in the industry and potential for new entrants to the industry. Intensity of competition implies greater incentives for mergers. Higher barriers to entry often mean larger companies within the sector resulting in greater probability that one of the companies has the resources to acquire others. If suppliers have considerable bargaining power then vertical mergers (company buying up its supplier) are more likely. If an industry has several substitutes then horizontal mergers (company buying substitute producing company) are more likely. If consumers have several choices in an industry it is more likely that the industry will consolidate. This discussion clearly shows the value of five forces analysis in the determination of motives for mergers. Sudarsanam (2003) argues that after due analysis of five forces a firm may attempt to change the configuration and increase its competitive advantage through mergers. The author argues that if profitability is depressed in an industry due to the threat of new entrants, a merger that generates substantial scale economies to move the firm beyond MES of production may raise the entry barriers to new entrants. This author would like to suggest that airline consolidation in Europe is strongly driven by this rationale. It is important that the key structural factors should be amenable to change through mergers. Otherwise the merger might not produce any value at all. Sometimes as pointed out in the literature waves of mergers may take place in the supplier and distributor industries in response to a merger in the main industry as shown in Tomkins (2000). There is some evidence in the empirical literature that in the European airline industry, factors[7] such as increasing bargaining power in procurement of aircrafts, reducing operating costs at out stations, rationalising maintenance and overhaul costs and obtaining synergies in IT systems are all cited as factors motivating mergers (Spinetta, 2006).

Some academics argue that improved management, improved research and development and improved distribution are other motives for M&A. Gaughan (2002) argues that while the importance of the improved management motive is not empirically significant, R&D and distribution motives are demonstrated by high profile mergers such as Pfizer, Warner-Lambert (Harris, 2001) and Ames department stores acquisition of Zayre[8] (Berg, 1990). However the literature also has strands that criticise this motivation for mergers especially in the European airline sector. Antoniou (1998) argues that horizontal M&A has several disadvantages such as soaring levels of concentration, increased condition around large hubs, erosion in the quality of service offered and deterioration of the industrial relations climate. The author therefore suggests that US style complete deregulation is not advisable in Europe. In particular this author raises the issue of the trade off between enhanced competition and oligopolistic structure/ cooperative behaviour.

2.9 Tax Motivations

Motivations of tax benefits are another important determinant of M&A mentioned in the literature. Gilson, Scholes and Wolfson (1988) underline the theoretical framework of tax- motivated mergers. They find that for a small fraction of mergers tax gains are a significant motive. Carla Hayn (1989) argues through her empirical analysis that aspects of potential tax benefits such as net operating loss carry forwards and unused tax credits positively affect announcement period returns of firms involved in tax-free acquisitions. In fact Gaughan (2002) notes that whether the transaction can be structured as a tax-free exchange is sometimes the prime determining factor of the M&A deal. Buyers could back out if the deal loses its tax-free status. Simularly sellers often use the tax status as a bargaining chip especially when negotiating with multiple bidders. In fact there is considerable evidence in the literature that tax-free reorganization of merging firms is a very valuable side benefit of M&A.

The above discussion on the literature on mergers and acquisitions outlines the key motivations and analyses the trade offs that drive M&A activity in any industry. The major themes and trends are highlighted and the various economic / model based approaches that can be used to study motivations for mergers are detailed. However it is important to recognise that despite these several theoretical arguments for mergers there is considerable evidence that M&A activity does not create any value for acquiring firms (Edghill, 2007). The target firm on average gains a value of 25% from such M&A activity. Further there is evidence that M&A activity creates value only when the resources and capabilities of the managers of the firm meet the criteria of RBV (resource based view). [9] The competitive advantage from doing M&A entails different aspects from the point of view of the bidding firm and the target firm. The figures below illustrate some of these issues.

M&A activity within any industry introduces changes, modifies the rules of the game and has far reaching impact on the consumer. This is true of the airline industry in Europe as well. It is within this context that the paper has studied the various strands in the M&A literature. From this comprehensive literature review a clearer understanding of the motives for M&A has emerged. Using this secondary literature in the next section the paper will analyse how the European M&A in the airline sector has evolved and attempt to justify the trends within the sector. Applying the economic logic gleaned from the extensive literature review the paper will evaluate the motives for M&A in the European airline industry and examine to what extent they conform to or depart from the classical motivations as outlined above.

III. Methodology

Methodology of research is best represented in terms of the research onion as shown in the figure below, p102

Figure

It encompasses six main segments of information, which include: philosophies, approaches, strategies, choices, time horizons and techniques and procedures. Each of the outer layers of the onion has a direct impact on the lower layer. Therefore philosophy determines approaches, which define strategies and choices that in turn influence time horizons as well as techniques and procedures.

Given the fact that the research question stems from an investigation into business arguments and economic logic driving M&A in European airline industry, this author would like to argue that an interpretivist stance is likely to be most appropriate. The social world of business and management is not simplistic and cannot be easily generalized into laws/rules like the physical sciences as argued by Saunders et al. (2007). However some aspects of critical realism as defined by Bhaskar (1989) would need to be incorporated as many of the processes and motivations driving mergers are invisible and can only be understood through the practical and theoretical processes of the social sciences.

3.1 Approach

The research process would necessarily involve a combination of two methodological approaches i.e. deduction and induction. Given the fact that there exists a large theoretical literature underlying mergers and acquisitions, one part of the research will necessarily adopt a deductive reasoning and move from a hypothesis to the data as argued by Robson (2002). On the other hand some aspects of M&A in Europe could be distinctive and different from elsewhere and therefore the research may have to move from the data and build up a theory as argued by Easterby-Smith et al. (2002). Naturally both these approaches would have to intersperse within this dissertation. The main differences between the two approaches are summarised in the table below:

Deduction emphasises

Induction emphasises

3.2 Nature of Research

The nature of the research question in this dissertation suggests that it is an exploratory study aimed at finding out what is happening in the European M&A market space with special emphasis on airlines. As argued by Robson (2002) the idea is to gain new insights, ask questions and assess phenomena in a new light. One of the great advantages of this type of research is that it is flexible and adaptable to change. In other words as and when this author finds new information about M&A in the airline industry in Europe an attempt will be made to synthesize this information into the various strands of arguments already developed.

3.3 Data

The Paper will use two main types of data namely primary and secondary data. The primary date will essentially be sourced from semi-structured interviews conducted with experts in the European airline sector. This will include Chief Financial Officer (CFO), industry analysts and academic experts. The semi-structured interview is a classic tool used in exploratory research. King (2004) argues that such interviews are non-standardised and allow the researcher flexibility to work around broad themes. It also enables different questions to be added and eliminated from the question set based on the responses of the interviewee. This is especially useful because in this dissertation the author does not want to structure the interview around certain set themes. The interviews will also use open and probing questions as argued by Saunders et al. (2007). This is because such questioning will reveal the complex nature of the topic and allow the respondents to raise related issues that are relevant. It will also help to use reflection in order to probe any given theme.

In order to present the findings of this research an attempt will be made to use exploratory data analysis approach (Tukey, 1977). Diagrams and tables will be used consistently and effectively throughout the analysis. Given the fact that trends are best illustrated through bar diagrams and histograms, these devices will be used as appropriate.

The paper will try to use a hybrid approach involving induction as well as deduction. As argued Saunders et al (2007) most empirical research tends to use a mix of deduction as well as induction. In deduction the researcher proceeds from a theory to the data where as in induction he proceeds from the data to frame a theory. Studying mergers and acquisitions within the airline industry in Europe, would necessarily involve examining available data on the industry to analyse trends and themes. At the same time the paper will also use the theory of M&A to inform the analysis. Thus a mix of deduction and induction will be used.

In presenting the analysis of findings from the literature review a mix of discourse and narrative analysis will be used. Coffey and Atkinson[10] (1996) argue that this form of analysis normally takes a five-step approach in order to explain and analyse the narratives. For example presenting the various themes that exist within the M&A literature in the airline industry will form one part of the paper. Then this author will analyse many of these themes/ trends. In essence a sequential procedure will be used in order to ensure that all the themes within the literature are analysed.

In line with this exploratory nature of this study it is but natural that the paper will use strategies that include surveys of existing literature, exploration of case studies and interviews with experts in order to buttress the main themes. As pointed out by Saunders et al. (2007) the survey strategy allows the use of both descriptive and inferential methods with respect to the collected data. A survey strategy also gives more control to the researcher during the research process. The other advantage with this survey methodology is that it allows the use of techniques such as semi-structured interviews. In this dissertation this author will use such interviews with experts in the European airline sector. This allows a more detailed exploration of the motivations for mergers in this sector.

The paper will use standard strategic models such as the 5-forces framework, synergy paradigms etc. to analyse the data. Porter's (1985) five forces framework is useful device to analyse the dynamics of any gives industry. Using forces such as intensity of competition, availability of substitutes, barriers to entry, bargaining power of buyers/ and suppliers, the analysis determines the reasons for an M&A in any given industry. Therefore such an analysis is extremely useful in the context of this dissertation. Similarly understanding pricing pressures and analysing cost structures is a vital tool to investigate the rationale for M&A.

3.4 Reliability and validity

As pointed out by Easterby-Smith et al. (2002) reliability measures the extent to which data collection techniques or analytical procedures yield consistent findings.[11] Given the qualitative and interpretational orientation of this paper, it would not be reasonable to expect results to be completely replicable by other researchers. However every attempt will be made to evolve a consistent and balanced approach while analysing the findings and framing the results.

Saunders et al. (2007) underline the fact that validity is about whether findings are what they appear to be. For example, if one of the findings is that mergers are motivated in airlines by political forces and managerial quest for domination, the paper will need to examine to what extent this is true and to what extent it is false. Some of the obvious threats to validity such as logic leaps/ false assumptions (Robson 2002) will need to be carefully managed during the write up.

3.5 Ethical issues

The secondary data accessed in this paper comes from the public domain and therefore there are no privacy or confidentiality issues. However given the semi-structured interviews to be conducted an attempt will be made to follow all the ethical issues outlines in Saunders et al. (2000). The author mentions privacy, voluntary nature of participation, maintenance of confidentiality of data as some of the prime issues especially when dealing with interview data. The author will make sure that all the interviewees are informed about the voluntary nature of their participation and the fact that the data collected will be confidentially handled. In all primary and secondary analysis as pointed out by various authors the avoidance of harm to any of the interested parties will be the cornerstone of the policies of this paper.

IV. Analysis of findings

There are several economic motives underlying mergers as outlined in the literature. At different times/ phases in the industry life cycle, different motives drive consolidations and mergers. It is clear from a careful examination of the literature review that motives for mergers are industry specific and arise out of the complex interplay of many economic factors prevalent in that industry. For example in pharmaceutical industry, the need for rationalisation of the drugs pipeline and the R&D synergies arising out of the same, could be a major motive for mergers whereas in the telecom industry grabbing market share and adding value added services could be the motivating factor. It is therefore essential to study the fundamentals of any given industry before generalising about the economic motives of mergers within that industry.

In the EU airline sector several authors within the literature document the fact that mergers and acquisitions directly target the operating efficiencies of higher traffic density. There is considerable evidence that significant cost savings can be extracted through alliance networks. Within the airline industry both in Europe and across the globe, there is considerable evidence that alliance networks are able to afford discounts to passengers due to lower costs. However this is not necessarily supportive of the need to merge. In fact if alliances and networks can gain airlines the cost optimisations that they require there is no need for them to indulge in a costly deal to merge. Yet there is evidence within the literature that mergers improve route optimisation and passenger service significantly more than alliances ever could. This suggests that M&A within the EU airline sector is increasingly driven by the cost optimisations that can be achieved. Industries cost dynamics have increasingly put pressure on large hub-and-spoke carriers to reduce the cost per seat-mile-gap between then and low cost discount airlines.

As shown in the graph above low cost carriers have a significant advantage and spend less then half of what hub-and-spoke-carriers do. A large part of this cost difference is due to build- in cost penalties of synchronised hub operations, long aircraft turn around times and slag built into schedules. Further the highly sophisticated IT systems and infrastructure adds to the cost. In such a scenario any cost savings arising out of consolidation of routes, rationalisation of infrastructure and better flow are welcome for any large airline. This author would like to argue that aspects of cost restructuring are a major economic motive for mergers in the EU airline industry. Further as pointed out in the literature review gaining scale has tremendous advantage in terms of increasing bargaining power in procurement of aircrafts, reducing operating costs at out stations, rationalising maintenance and overhaul costs and obtaining synergies in IT systems. There is considerable empirical evidence in the literature, which include studies as Romero and Salgado (2006) for the existence of economies of density and economies of network size. Given the fact that the easiest route to gaining such economies is through horizontal mergers this author would like to argue that these factors represent a major motivation for deals within the EU airline sector. This is substantiated dramatically in the air-France- KLM case in which significant cost savings were generated due to these factors.

There is some evidence within the literature that alliances and joint ventures are able to significantly increase market share. Petersen (2004) finds evidence that 40% of synergies planned within the air France-KLM merger were derived from additional revenue generated by the alliance. Much of this network optimisation is reiterated within the EU airline studies. When two major airlines consolidate, not only are they able to scientifically redesign traffic routes in order to improve traffic density, this author would like to argue that such joint entities are also able to spread maintenance costs, achieve purchase economies and so on. The use of each other's brands can also result in considerable marketing advantage. Not only are players in the airline industry able to use each other's customers' bases but also route network optimisation often results in an ability to serve new destinations or existing destinations at better more convenient times for passengers. This results in an ability to target different segments of the market and increase share at an expense of other airlines. In fact the KLM-air France merger clearly demonstrates and illustrates this point. The market share of the combined entity was proved to be much higher then the market share of the sum of the two pre-consolidation entities.

Diversification seems to be another major motivation driving mergers in the EU airline industry. Given the fragile nature of consumer brand loyalty within the sector, acquiring different consumer bases considerably de-risks the business model of large carriers. Being dependent on a single customer base is likely to generate problems for a carrier especially in the context of a segmented population like the EU. If brand-loyal customers switch to other airlines, all of a sudden a profitable business model suddenly starts looking very weak. By gaining many more customers basis in a short span of time through a merger an airline is able to de-risk its business model and thus become more to both shareholders as well as financials.

There is some evidence that economies of learning do play a part in airline mergers. Knowledge transfer, skill transfer and the benefits of experience can significantly impact upon the performance of a combined airline. The classic case of air France-KLM demonstrates the importance of this motivation.

Pre-and-post-operational matrix such as plant load factors and revenue per kilometre shows significant improvement post mergers as illustrated in the graphs below for the air France-KLM case. This suggests that there was considerable exchange of skill and information from both parties to the deal.

Horizontal mergers seem to be the main-stay within the EU airline industry. This author would like to reiterate the importance of this motivation in the context of the increasing competition and the need to grab market share. The strong competitive presence of low-cost airlines implies that unless large carriers are able to increase their reach through an expanded network, it is unlikely that they will be able to sustain their market share. Growing organically through patiently expanding capacity and gradually gaining customers is no longer an option within the European airline industry. In recent times higher fuel costs are further eroding, the profit margins of these carriers and therefore horizontal mergers are very much the main stay of the industry.

In terms of the resource-based view of M&A as pointed out in the literature review, reconfiguration of R&C (resources and capabilities) is a very important motivation for mergers in both the EU and the US. It is difficult to analyse to what extent the EU airline industry mergers are driven by this motivation. However it is obvious to even a perfunctory analyst that the nature and dynamics of the airline industry would imply an importance to the reconfiguration to the resources and capabilities. Maintenance facilities, landing berths, aircrafts etc. represent resources that cannot be easily transferred. When two airlines merge these facilities can be rationalized across the operations of the two entities resulting in a release in value for the merged entity. Similarly, different airlines have capabilities with respect to different types of customers, freight handling, ticketing, alliances with travel agents, hub management, spoke access and so on. By merging capabilities can be rationally redeployed to maximize profits for the combined entity. There is considerable evidence in the literature that in the air France-KLM case this is what actually occurred and the combined entity was ably to extract considerable value out of the deal.

The need to exploit financial synergies is yet another motivator that this author feels should have a significant impact within the EU airline industry. The case of air France- KLM illustrates how the combined entity was able to enjoy significant advantage in borrowing costs post-merger. (Capron et al) while there is a consensus within the literature that larger entities, by definition, are relatively less risky and therefore are able to borrow more on flexible terms and at cheaper interest rate. Given the need for rationalising lease costs within the airline industry in general it is not surprising to note that the financial economies possible through horizontal mergers are a significant motivating factor for them. Similarly the literature clearly shows that EU airlines are often more leveraged than their global counterparts and therefore any reduction in debt servicing burden is a welcome development.

Growth opportunities in either of the firms that are merging that cannot be efficiently financed singly is often cited within the literature as one major motivation for M&A. in the EU airline industry there is evidence that smaller firms are at a significant disadvantage in capturing the value out of growth opportunities within their market. Therefore a merger between a larger and a smaller firm can often result in profitable extraction of positive NPV projects in either firms' portfolio. Further the combined entity is also able to raise finance for these projects more efficiently. The Air France-KLM case typifies such a motivation for merger.

There is little evidence of either tax-based motivations for mergers or the hubris argument within the EU airline industry. While this is not surprising due to the predominance of major economic factors, yet cultural and political factors do play a significant role within the industry. The air France-KLM merger illustrates the importance of cultural similarities between the airline companies. In fact several authors within the literature argue that the phenomenal success associated with the air France-KLM deal is due to the fact that both the airlines were culturally similar to each other and shared several socio-cultural characteristics.

Application of 5 forces model to the EU airline industry ( 3-4 P)

Implication of the analysis to M&A motivations within EU airline industry (2p)

IV List of references

Books

  1. Antoniou, A. 1998, The status of the Core in the Airline industry: The case of the European Market. John Wiley & Sons, Ltd.
  2. Besanko, D & Dranove, D & Shanley, M, 2000, Economics of strategy, John Wiley & Sons, New York, p 37
  3. Bhaskar, R 1989, Reclaiming Reality: A Critical Introduction to Contemporary Philosophy, Verso, London
  4. Brueckner, J.K./ Pels, E., 2004, European airline mergers, Alliance, Consolidation and Consumer welfare, April 2004, university of Illinois.
  5. Capron, L & Hulland, J., 1999, Redeployment of brands, sales forces and general marketingmanagement expertise following horizontal acquisitions: A rescource based view, Journal of Marketing, 63
  6. Carlton, D & Perloff, J, 1994, Modern Industrial Organizations, 2nd ed., HarperCollins, New York p.502
  7. Clemente, M & Greenspan, D, 1998, Winning at mergers and acquisitions: The Guide to Market- Focused Planning and Integration, John Wiley and Sons, New York, P.46
  8. Coffey, A and Atkinson, P. 1996, Making sense of Quantitative data, Thousand Oaks, CA, Sage.
  9. Easterby-Smith, M & Thorpe, R &Lowe, A 2002, Management Research: An Introduction (2nd edn), Sage, London
  10. Gaughan, PA, 2002, Mergers, acquisitions, and corporate restructurings, John Wiley & sons, Inc. New York
  11. Gilson. R, Scholes. S, Wolfson, M. 1988, Taxation and the Dynamics of corporate control: the uncertain case for tax-motivated Acquisitions, New York, Oxford university press
  12. Gort, M 1974, Diversification, Mergers and Profits, in the corporate merger, William A. Alberts, Chicago, p38
  13. King, N 2004, Using interviews in qualitative research, In Cassell, C. and Symon, G. (eds.) essential guide to qualitative methods in organizational research, London.
  14. Porter, M, 1985, Competitive advantage, Free press, New York, chapter 7
  15. Robson, C 2002, Real world Research (2nd edn), Oxford, Blackwell
  16. Saunders, M & Lewis, P & Thornhill, A, 2007, Research methods for business students, 4th edition, Pearson education Limited, England.
  17. Sudarsanam, S 2003, Creating value from mergers and acquisitions- the challenges, Pearson Education Limited, England
  18. Tukey, J.W 1977 exploratory Data Analysis, Reading, MA, Addison-Wesley
  19. Williamson, O, 1975, markets and hierarchies, Free press, New York

Interview

  1. Buyck, C, 2005, interview: Air France KLM group, www.atwonline.com/channels/airlineFocus/articles.html?articleID=1246 Date viewed 4/10/2007
  2. Friensen, M. 2005, Capital market's assessment of European Airline mergers and acquisitions- the case of Air France and KLM, Swiss Transport research conference
  3. Spinetta, CJ. 2006, Cross border Mergers & Acquisitions, The Air France KLM story, The Netherlands

Internet

  1. Businessweek 2003, European Airline Consolidation fever?, October 2, edited by rose Brady www.businessweek.com/magazine/content/03_41/b3853082_mz015.htm Date viewed 14/10/07
  2. Economist, April 4th 2007, The prospect of more open skies across the Atlantic in shaking up Europe's airline www.economist.com/business/PrienterFriendly.cfm?story_id=8960619 Date viewed 4/10/07
  3. Tagliabue, J, Air France and KLM to merge, becoming Europe's No1 airline, www.globalpolicy.org/socecon/tncs/mergers/2003/1001airfranceklm.htm Date viewed 14/10/07

Lecture Notes

  1. Edgill, S, 2007 mergers and acquisitions: an introduction, Fin 354 A2007 week 1

Periodicals

  1. Air France KLM, August 2007 Traffic, September 7th 2007, Air France corporate communications
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  3. BebPak 1989, Brings back the shine to steel cans, Wall street journal, 8 June
  4. Berg, E 1990, Ames' Rocky retailing marriage, Wall street journal, 11 April
  5. Berger, P and Ofek, E 1995, Diversification's effect on firms value, Journal of financial economics 37, no 1
  6. Bradley, M, Desai, A, Han Kim, A 1983, The rational behind Interfirm tender offers: information or Synergy, journal of Financial Economics 11, no 1 (April) pp. 183-206.
  7. Carey, D (moderator) 2000, Lessons from Master Acquirers: A CEO roundtable on making mergers succeed' Harvard Business Review, may/June, 153
  8. Dodd, P1980, Merger proposals, Managerial discretions and stockholder wealth. Journal of financial economics 8, (June 1980), pp. 105,138
  9. Elgers, P and Clark, J 1980, Mergers types and shareholders returns: Additional evidence, Financial management issue 2
  10. Elgers, PT and J.J. Clark 1980, Merger Types and shareholder returns: Additional Evidence, Financial management 9, Issue 2 (Summer 1980), pp. 66-72
  11. Harris, G 2001, With Big drugs dying, Merch didn't merge-it found new ones. Wall street Journal, 10 January
  12. Hayn, C 1989, Tax attributes and determinants of shareholder gains in corporate acquisitions, Journal of financial economics 23, no.1 (June), pp. 121-153
  13. Hayn, C 1989, Tax attributes and determinants of shareholder gains in corporate acquisitions, Journal of financial economics 23, no.1 (June), pp. 121-153
  14. Hayward, M and Hambrick, D 1995, Explaining premiums paid for large acquisitions: evidence of CEO Hubris, unpublished manuscript, July
  15. Higgins, R & Schall, L, 1975, Corporate Bankruptcy and conglomerate Mergers, Journal of Finance 30 (March 1975), pp. 93-113
  16. Jensen, M & Ruback, R, 1983, The market for corporate Control: The Scientific Evidence, Journal of Financial Economics 11, no 1-4 (April 1983), pp.5-50
  17. Kim, E & Singal, V, 1993, Mergers and Market Power: Evidence from the Airline Industry, American Economic Review 83, No.3 (June 1993), pp. 549-569
  18. Knapp, W 1990, Event analysis of Air carrier Mergers and Acquisitions, review of economics & statistics, November 1990, Vol. 72, Issue 4, 703-707
  19. Levy, H & Sarnat, M, 1970, Diversification, portfolio Analysis and the Uneasy Case for Conglomerate Mergers, Journal of Finance 25, no 4 (September) pp. 795-802
  20. Lichtenerg, F & Siegel, D, 1987, Productivity and changes in Ownership of manufacturing plants, Brookings Papers on Economic Activity 3 pp.643-683
  21. Malatesta, P 1983, Wealth effect of mergers activity, journal of Finacial economics 11, no 1 (April) , pp. 178-179.
  22. Mester, LJ 1987, Efficient product of Financial services: Scale and Scope Economic Review, federal reserve Bank of Philadelphia, January/February, pp15-25
  23. Peteraf, MA 1993, The cornerstones of competitive advantage: A resourced based view, Strategic management journal, 14, p179-191
  24. Roll, R 1986, The Hubris Hypothesis of corporate takeovers, journal of business 59, no 2
  25. Slovin, M.B, Sushla, M.E./Hudson, C. D.1991, Deregulation, Contestability and Airline acquisitions, Journal of financial economics, December 1991, Vol.30, Issue 2, 231-235
  26. Stillman, R, 1983, Examining Antitrust Policy Towards Mergers, PhD Dissertation, University of California at Los Angeles, 1983. Journal of Financial Economics 11, no.1 (April 1983), pp. 225-273
  27. Tomkins, R, 2000, Manufacturers strike back, Financial Times 16th June
  28. W.G. Lewellen 1971, A pire rational for the conglomerate Merger, Journal of finance 26, no.2, May, pp. 521-545.
  1. VAB = The combined value of the two firms
  2. VB = The market value of the shares of B

    P = Premium paid for B, E= Expenses of the acquisition process.

    VA = A's measure of its own value

  3. There are several ways in which revenue enhancing synergies can be achieved such as sharing of brand names, distribution networks etc. these synergies are also difficult to achieve and quantify.
  4. Experts in the industry suggest that being able to fly with specialist airlines in different sectors with fares that can be combined to provide a best possible quote is attractive to consumers. Similarly using a joint sales and management team to liaise with large institutional customers helps to reduce marketing and distribution costs.
  5. Sudarsanam 2003 clearly points to M&A as one of the main channels to quickly obtain economies of learning.
  6. Gaining scale in the airline market in Europe seems to be vital especially after the dismantling of intra-country barriers within the continent. The larger market implies that rationalisation of routes, hubs and networks is vital for competitive edge.
  7. The case of Mobil-Superior Oil combination is quoted in the literature as a classic example of assurance of supplies.
  8. The CEO of the joint airline (Air France KLM) clearly points out in his speech to the Nyerode European Business forum, that all these factors are strategic and aimed at gaining competitive advantage through changing the structure or the rules of the game in the industry.
  9. The Pfizer-Lambert merger was motivated by acquisition of R&D while the Ames department store wanted to exploit the distribution synergies in the value chain of the target business.
  10. As argued by Edghill (2007) when the merger creates resources that are valuable, rare, hard to duplicate and non-substitutable then it meets the RBV criteria.
  11. Structural elements of narratives include questions such as "What is the story about?" , "What happened , to whom, whereabouts, and why?", "What consequences arose from those?" etc.
  12. The authors suggest that reliability can be assessed through questions such as " will the same results be obtained on other occasions or in other conditions ?", "Is the research transparent ?", "will other observers reach similar results ?"

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