MCKINSEY & COMPANY
Large airline mergers loom on the horizon, yet past transactions have often not paid off. So what are the rules for making them work?
The track record for merger and acquisition deals in the airline sector is hardly encouraging. The evidence says that even those deals that have gone through have yielded little or no real value. Take just one classic statistic. There have been more than 50 airline transactions in the European and US industries over the past 15 years or so, yet the total value of those transactions is more than the current market value of the whole industry. While airlines are not alone in generating such shocking statistics, there are few industries where the picture looks quite so bad.
Despite this sobering history, the industry appears to be lining up for another round of consolidation. That raises the question of whether they can succeed this time where others have failed. The underlying logic behind consolidation is, on the face of it, rational and compelling. The value is clearly there, but capturing it remains elusive.
Evidence suggests that the potential upside for airline mergers is significant. Work by McKinsey & Company suggests that a merger of two mid-sized carriers could unlock synergies in excess of 7%. Of course unlocking those synergies is easier said than done. The process starts with understanding the business logic behind merger benefits.
Some benefits are those that apply to any industry. For example, the increased scale of the newly created entity will bring enchanced bargaining power with key suppliers. Indeed, added benefits can accrue as the integration process itself uncovers opportunities that the pre-merger companies may have missed.
The new entity will also benefit from cost rationalisation. While grabbing fewer headlines than new routes and aircraft orders, areas such as parts inventories, back office functions, sales forces or management teams are all nicely scalable. The usual messages also apply about massaging balance sheets and sharing skills around the combined company.
In addition, there are some powerful merger benefits specific to the airline business:
- Network optimisation - Single control over a combined network increases connectivity, aircraft utilisation and route rationalisation.
- Increased market power - The power of combined schedules, frequent-flier programs (FFPs), agency agreements and corporate contracts should result in a substantial increase in fair-share revenues in focus cities.
- New market growth - Combined home market presence will often permit new routes that would not have otherwise been profitable, providing an often-overlooked opportunity for growth.
- Improved alliance position - Bargaining power with existing and potential partners should increase markedly.
Unfortunately, many airlines find these benefits eaten away by merger costs. Expensive customer service disruptions are common, while one-time merger costs, ranging from fleet repainting to severance packages, exceed estimates. Tricky labour negotiations can also result in upward harmonisation of wages and work rules, and may lead to caps on job cuts. There are also concessions demanded by communities and regulators.
Also, companies involved in mergers stop making day-to-day decisions during the integration process. This "strategic paralysis" is perhaps the biggest merger-related cost, as competing airlines take advantage of the distraction, poaching key personnel and customers and launching new strategic initiatives - such as product enhancements - with long lead times. The ground gained by the competition can be difficult to recover.
Understanding the unique challenges of airline mergers is vital. While all mergers are difficult and each industry has its unique challenges, mergers in the airline industry are arguably among the most complex.
Perhaps the single greatest challenge in airline mergers is managing multiple and powerful stakeholders. Politicians, regulators, labour and consumers each have different objectives and all have a potential impact on the value of the deal. Politicians and public alike have proved inherently suspicious of the motives when airlines announce merger intentions, fearing that consolidation is merely an attempt by the participants to limit competition and increase prices. Such fears may be fanned by competitors opposed to the deal, who urge regulators to rule against mergers. On several recent occasions, regulators in Brussels and Washington have done just that.
Consumers oppose mergers as well. While airlines try to articulate the benefits of increased network scope, customers fear "price gouging" and reduced service. Here too, the airline is more than just a provider of transportation, with customers bound in by loyalty programmes and the like. FFP "tier" alignment alone can consume months of management time and energy.
The most vocal - and potentially powerful - stakeholder is labour. Unlike investors and management, labour - particularly the pilot group - is almost entirely dependent on the future of its airline. Seniority systems and shallow pay curves that reach lofty heights make senior employees captive to an airline.
The American Airlines purchase of Reno Air met with classic hostile labour resistance. While American was able to eventually complete the integration, the damage caused by illegal pilot actions effectively doubled the price of the acquisition.
Stakeholders are formidable and highly focussed opponents with a lot to lose They have clear priorities and organisations capable of going after them. That is also true of the ultimate stakeholders - the airline investors. It is no coincidence that the share prices of the acquirers in recent US deals took immediate post-announcement hits.
Airline mergers also have to cope with inherent complexity of the air transport operation. Even in the best of times, the "product" has a high service failure rate. Delays, cancellations, lost bags and long lines are part of the daily operation of any airline, whether it is digesting a merger or not. Failing to adequately plan for operational transition has been the undoing of many airline mergers.
Adding to the complexity is an unusually long planning horizon. Even small changes to the schedule require months of advance planning, and 85% of an airline's cost structure is fixed to its schedule. The general rule in successful post-merger management is that it is critical to get value quickly. But in airline mergers, a large portion of the synergies are revenue improvements, especially given the constraints in reducing cost. Unfortunately, these benefits require long-lead time decisions supported by careful planning. By the time the dust settles on the merger, these critical decisions are often far, far behind schedule.
The 10 Commandments
Successful airline mergers require getting a lot of things right. While there is no single recipe for success, we believe that a few "musts" go a long way to making mergers work. Careful adherence to the "10 commandments" of airline post-merger management will ensure airlines get the most out of a merger.
1. Communicate a vision beyond "synergies"
Synergies speak well to shareholders, but not to the other stakeholders whose commitment will define the success of the merger. Labour, consumers and regulators each need to believe that there are specific benefits for them in the deal. Growth opportunities, an enhanced network and corporate pride could all be among the gains. Perhaps most importantly, management will need strategic context to help it make day-to-day decisions that affect the integration process. A vision that includes the benefit to each stakeholder and a clear articulation of the end-state will help ease uncertainty and provide everyone with a clear direction and a compelling "reason" to tolerate the integration hassle.
2. Deal with the "emotional" issues up front
Any successful merger involves a number of emotional decisions that - by definition - will disappoint a number of people. That said, management and the board should make those decisions quickly and decisively. The top team, a rough organisational structure and location of key jobs should be decided at the start of the merger process - if possible before a public announcement. Trying to carry out a successful merger with two departmental managers vying for each position is likely to spawn counter-productive behaviour and create a climate of uncertainty.
Once the top management team is announced, it is helpful to quickly identify a shortlist of additional "keepers" from both organisations, and let them know how they will be taken care of. Doing so preserves their knowledge, at least through the transition. This is particularly important for executives from the acquired carrier, who may perceive themselves as underdogs in the race for jobs and thus be likely to leave hastily.
For other positions, it is extremely important to be very clear on the selection process and criteria up front. Will excellence be the only driver, or is balance also an objective? This process must be visibly adhered to if trust is to be established in the new management team.
3. Exhibit value delivery - not just integration
An acquirer's stock price will usually fall the day the deal is signed. as investors assume that it will fail to create value in excess of the purchase price and punish accordingly. There is significant upside to proving them wrong quickly. While the short-term savings potential will vary dramatically based on the amount of natural overlap between the two carriers, the first 100 days present the greatest opportunity to impress. Senior management must instill a norm that all departments will identify quick wins and subsequently that leaders at all levels will be accountable to meet their savings targets.
In one recent airline merger characterized by significant overlap, the "quick wins" program saved $100 million in the first 100 days - 4% of revenue. The airline quickly attacked contract alignment, exited unprofitable routes, rationalised real estate and eliminated redundant advertising. The stock price responded accordingly.
4. Integrate finance, planning and IT first
While the integration programme will eventually cover most functions, some are required to run the merger itself - notably those involved in tracking and planning. An integrated finance department, for instance, is critical to ensure adequate tracking of the integration process and management of cash flow - now under pressure from the extraordinary costs of the merger. A process for tracking expenditure and savings must be quickly established by the department and any shortfalls must be flagged for immediate attention.
These departments should also develop common market-profitability measures. A large part of the synergy in an airline merger comes from network optimisation. Without common measures, however, the network team will get buried in apples and oranges, unable to agree on solutions.
An all-too-common response from IT and planning functions is that the department is already too busy to deal with integration. So, an early task is to eliminate projects that will be irrelevant or duplicated in the integrated company.
5. Keep labour involved, but don't get caught in the middle
The role of labour in approving the transaction will vary depending on the airline's ownership structure, but fear and uncertainty will always drive union behaviour. In same-country mergers, day-to-day integration decisions such as network realignment and co-mingling are likely to be of great interest to the unions, particularly where work rules, salaries and unions differ between the two companies. With cross-border mergers, personnel in hub operations will initially be much less affected, but will worry more about the risk of shifting operations to the other carrier in the longer term.
A consolidated pass policy - fully reciprocal, and preferably aligned to the more generous policy - is a relatively inexpensive way to buy some peace.
Where operations are being integrated, the most troubling issue of all will be the matter of seniority lists. One carrier's gain is likely to be directly offset by the other carrier's losses: suddenly, more junior employees in the consolidated company could be perceived as trumping more senior employees in the other.
Rather than get involved in union matters, recognise that upset and disquiet are unavoidable, and leave no-win issues, like seniority' integration to union leadership. Focus negotiations on high-priority issues where management is a direct stakeholder, such as intermingling agreements, relocations and severance packages.
6. Appoint a highly disciplined project team
Before the merger is announced, the two companies should agree on a disciplined project management team. That team should operate under clear protocols for identifying and implementing integration synergies, including a method for "breaking ties" where "best-practices" are concerned. The teams - typically one for each major area of synergy - should report dually to a line-management leader and an integration steering committee. The line leader must be committed to full implementation of the recommendations.
Finally, it is important not to go out of "merger mode" too soon. Just because the organisations are in place and the brand stabilised does not mean that integration is complete. It will typically take a year to stabilise the management decision processes and anchor the planning processes in the merged organisation.
7. Actively manage government and the regulator
Even after the merger has been approved, governments and regulators should be actively managed, especially if some tough decisions have to be implemented to reduce overlapping personnel or rationalize operations. It is critical to avoid legislated government "industry ombudsmen" who can be hastily installed and have short-term objectives that destroy long-term value for everyone.
Best practice in this arena includes identifying some "wins" for the government that can be implemented and trumpeted more broadly. They could include growth, new routes, greater levels of competition or visible price discounting.
8. Actively manage cultural integration
Airlines typically possess unusually strong cultures and identities - how often do bank enthusiasts hold a convention to trade old deposit slips? As employees often have a deep emotional attachment to the carrier, it is critical to actively manage the cultural integration at the front line. While company specific airline operations may require that employees be kept "separate" for long periods of time, it is important that cultural integration begin immediately. Managers and supervisors need to be prepared to "walk the walk" from day one, projecting a common voice to front-line staff.
At the top levels, organisations make decisions in different ways, with different requirements for facts and analyses. The corporate leaders should work together to actively identify these differences and draft new cultural norms. Integration is a rare opportunity to start fresh and shed dysfunctional habits. Symbolic gestures are often very important to drive-home planned cultural changes. Changes in dress-code; presentation formats; office layout; and meeting timing, locations, and structures can be powerful catalysts for cultural change.
9. Commit resources to communications
Communication with affected parties is paramount, and will require a talented team and a genuine and substantive strategy. Consistently and directly tell stakeholders where the airline is in the process and what is around the corner. Employees should know exactly where to look for the latest news on the integration process.
The communications team should define a clear channel strategy for updates, special announcements, and "alerts" and stick to it. It goes without saying that communications should be honest, to the point and with minimal "spin." Airline employees are adept at identifying company "kool-aid" - and their trust is easily lost.
Actively communicating to customers is also important. A lot of very positive things happen after a merger. Consolidated FFPs, improved service and new routes all have significant value to customers. It is critical to articulate these benefits and then sell them hard.
10. Overestimate the customer service challenge
Managing the customer service challenge is harder than it sounds. Airlines are often eager to get valuable labour synergies out of customer service functions, when in fact an increase in customer resources may actually be required in the short term. For same-country mergers or those resulting in a single brand, the moment that the deal is announced, call centre volumes soar with passengers concerned about the fate of their itineraries, mileage and elite status. The sooner reciprocal customer service benefits are implemented, the sooner the gains of an integrated network are realised.
Without the power of a single brand, cross-border mergers depend on seamless service delivery to capture the benefit of increased market power. Processes, rules, standards and systems must be quickly aligned to create a uniform "feel." Customers will decide quickly whether there are real benefits from such a merger. The burden is on the airline to prove it.
In any industry, it is critical that the post-merger management process maintains a focus on value creation at every stage. Given this industry's track record and complexities, it is particularly critical for airlines.
Following the 10 commandments of airline post-merger management will not guarantee a smooth ride, but it should help avoid the worst of the turbulence and ensure that the shareholders see the value they are promised.
Source: Airline Business
