Mergers: After the honeymoon

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As consolidation continues among network carriers, history shows the success or failure of airline mergers hinges on the actual integration process, write Max Maruna and Peter Morrell of Cranfield University

Although 82% of married couples in the USA will reach their fifth wedding anniversary, only 52% will celebrate 15 years of marriage. Likewise, across all sectors, including the aviation industry, there is plenty of courting, but it is worth noting that more than half of consummated mergers fail to achieve their objectives.

Only a few tie-ups add value, while in some cases shareholder value is actually destroyed. In the USA there were 18 major airline mergers between deregulation of the domestic market in 1978 and July 2005. Of those, only the integration of Delta Air Lines and Western Airlines in 1987 was considered successful.

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The numbers vary widely, but various studies suggest 50-80% of all mergers fail to meet the financial or operational goals they set out to achieve. So why do most airline mergers not achieve their objectives? The answer is more often than not linked with failures and problems in the post-merger phase. Post-merger integration should ensure that calculated synergies are delivered, but executives seem to concentrate on getting the deal done rather than on resolving integration issues which emerge following the merger announcement.

While a good post-merger integration can overcome some misconceptions of the planning phase, a weak integration has the potential to destroy a well-conceived merger. This is even more significant in cross-border deals because differing country and business cultures create a new array of problems.

Airlines may decide to merge for various reasons, such as market access or to increase profitability. However, cost and revenue synergies (see table above) are a focal point in any deal and vary in size according to the specialities of the merger. Revenue synergies stem from a variety of sources but are always a function of traffic and yield.

NETWORK OVERLAP IS KEY

According to Matthias Hanke, partner at Roland Berger in Zurich, the biggest increase in yield stems from network overlap between merging airlines. After the merger, the new airline can reduce the number of frequencies on routes where the airlines were sole competitors. The new airline creates a monopoly on these non-stop routes and, at least initially, can earn higher yields.

In some cases fares can be increased by as much as 50%, but this will be restricted to a limited number of routes and will strongly depend on network overlap and anti-trust considerations. Yet, any increase in yield is likely to be short-lived as competitors come in and push yield downwards again. Taking all these factors into account, revenues might be improved by up to 3%.

On the other side of the equation, network overlap is also the most important area for cost reductions. "On the overlapping routes, the merged airline can reduce frequencies, use larger aircraft and improve load factors. Thus, the same number of passengers can be transported with fewer aircraft," explains Dr Philipp Goedeking, managing director at Airconomy in Frankfurt. "This gives the airline the opportunity to divest itself of older aircraft or even whole fleets and dispense with the related operating costs."

However there are also limits to increasing load factors. Dr Peter Belobaba, principal research scientist at the Massachusetts Institute of Technology's Department of Aeronautics and Astronautics, believes that load factors in excess of 85% do not pay off, as they only result in a spill of demand.

But how big is the overall cost saving potential in a full-scale airline merger? Taking all these factors into consideration, experts and several studies confirm that mergers yield a cost reduction potential of up to 7%, depending on the specific case.

There are also costs involved when two airlines combine. Michael Swiatek, former senior executive at Air New Zealand and a member of the management team during the merger with Ansett Australia in 2000, says that merger-induced costs can be substantial and may amount to up to 5% in the first year. These costs are can stem from the operational and technical implementation of the merger, remedies imposed by competition authorities and general post-merger integration problems.

Looking around, many mergers fail to deliver their assumed synergy potential and recent cases show that most airline integrations tend to fail in the post-merger phase. The most critical reasons for failure seem to be poor planning and execution of the integration, as well as underestimating the labour component during and after the two companies come together.

MERGER PLANNING

The integration of two companies comprises two layers of processes: transactional and integration processes. The transactional processes include the identification of the merger target, due diligence, negotiation and deal structure as well as regulatory approval.

The integration processes can be classified into three areas: strategic framework, planning and integration. During the strategic framework phase, objectives and targets of the merger are set and the management team is briefed on the integration strategy. In the planning phase, a number of plans are devised and the integration team designated. The main objective of the planning phase is to plan the integration for at least the first three months. Planning should be completed before the first day of the merger, so that the actual integration can be started with regulatory approval. In the integration phase, the actual integration of the airline is done by the integration team.

Airline functions should be integrated according to level of difficulty. As Swiatek puts it: "In a merger you should go for the low hanging fruits first." Commercial functions, such as network planning, sales and distribution and customer services should be integrated in a first phase. Meanwhile, operative functions, such as people, IT, operations, administration and finance and related businesses should be integrated in phase two.

Powerful drivers which facilitate success in post-merger integration include over-communication, a strong integration team and top management involvement. Furthermore, the choice of the right integration speed - fast or slow depending on the situation - is important to ensure success.

The second most critical reason for airline merger integration failure is underestimating labour-related problems. The staff stress, problems with unions and safety-related costs top the list of pinch points.

When companies merge, it can trigger staff stress symptoms which ultimately result in a clash of cultures. This is dubbed merger syndrome". However, those symptoms can be combated by certain strategies such as communication and ventilation meetings.

The three most important unions influencing integration are those of the pilots, mechanics and flight attendants. The biggest hurdle is usually the integration of the pilot groups, as differing seniority lists, pay scales and as working rules are not easy to overcome.

Moreover, mergers such as the tie-ups between United/Piedmont, Austrian Airlines/Lauda Air show that the lower pay scales at one airline tend to be adapted to the higher pay scales of the other, but not vice versa.

However, former US Air Line Pilot Association representation director Seth Rosen says there are a number of approaches that can be used to find a common basis with the unions. These include involving them from the beginning of the process and exerting trust, openness and respect throughout.

Merging flight operations carries an especially high risk, compared with the amount of achievable synergies. This means that it may be beneficial to resist integrating the pilot groups, as long as they can reasonably be kept separate - as was the case with Lufthansa/Swiss and Air France/KLM.

The graph above shows the difference in integration strategies between US Airways/America West and Air France/KLM. Although unit costs rose substantially at US Airways/America West in the year following the merger, the increase was compensated for by higher yields. Meanwhile, capacity was reduced aggressively in line with traffic.

In contrast, Air France/KLM capitalised on complementary, rather than on overlapping, networks. Whereas yield rose in line with the yield of other European airlines, capacity rose significantly in the year following the merger in line with traffic changes.

Both mergers met their objectives. Air France/KLM decreased its unit costs and increased the productivity of its employees. As no major redundancies were made, no problems with unions arose. Over at US Airways/America West, the merger substantially improved its efficiency by shedding quite a sizeable part of its fleet and returned to profitability in the years following the merger.

Airlines do have strong financial incentives to merge. Those incentives take the form of revenue and cost synergies, as well as improved profitability once the merged carrier finally takes shape. Recent cases show that most airline mergers tend to fail in the post-merger phase. To avoid this, airlines should place emphasis on planning and execution as well as labour integration and IT problems, as they are the most common reasons for failure.

Although in today's climate there is more pressure than ever to consolidate, there is a limited bandwidth of potential mergers. On the one side they are limited by anti-competitive constraints and on the other side by economic feasibility.

ABOUT THE AUTHORS

Max Maruna is Max Maruna is chief operating officer of Avcon Jet, a corporate jet management company based in Vienna. E-mail: m.maruna@avconjet.at

Professor Peter Morrell is director of research at Cranfield University's Department of Air Transport. He was previously an economist with the AEA. E-mail: p.s.morrell@cranfield.ac.uk