Mergers and Acquisitions - International Airlines Group and British Midland International - Assignment Example

Mergers and Acquisitions Introduction A business may grow either internally or externally. As a part of internal growth, a business expands in its normal course activity by acquiring new assets, setting up better product lines and enhancing technology. On the other hand, external growth is a much quicker process. A business can take over a running business and through such corporate strategies, it can expand overnight. Such corporate strategies include mergers, acquisitions, takeover and amalgamation. Such external expansion has become very popular in the recent years. This is primarily because such expansions facilitate globalisation of company; improve competitiveness, free from trade barriers and promote capital flow between countries (Watson and Head, 2013). Under corporate restructuring, mergers and acquisitions have become a very important part of entry and expansion strategy. Companies are increasingly going for mergers with a view to avoid competition and gain some sort of monopoly. IAG’s (International Airlines Group) merger with BMI (British Midland International) is directed towards creating synergy in the Airlines industry and eliminating competition via a greater market power. IAG also believes that such consolidation of two businesses shall also help in eliminating some traditional problems that have plagued the industry for long. It shall also increase IAG’s participation in the global airline industry. Mergers and Acquisitions Mergers and acquisitions reflect an entire change in business activity. It is one of the major changes that a business might have to go in its life cycle. Listed here are a various types of mergers and acquisition that generally occur. Mergers In this method of takeover, the managers of firms, who are in conversation, decide to unite stocks of the two entities after seeking shareholder approvals. Such approval shall be of at least 50% shareholders for both the firm taking over and the one being taken over. A merger is more often than not, a cheaper mode of acquisition than the other methods discussed here. For example, merger between Compaq and Digital Computers resulted in Digital Computers lost its own identity and became a part of Compaq (Booth and Cleary, 2010). Acquisition In this process of takeover, Firm 1 buys all assets of Firm 2 only when the shareholders of Firm 2 grant their approval in majority. It is to be noted that such buyout generally happens when Firm two faces bankruptcy (Cornell, 2008). Type of Mergers and Acquisition 1.1. Horizontal Mergers & Acquisitions A merger that occurs between companies that operates in the same industry in known as a horizontal merger (Brealey, Myers and Allen, 2010). 1.2. Vertical Mergers & Acquisitions A merger that occurs between businesses associated by activities on the same production process is known as a vertical merger (Brealey, Myers and Allen, 2010). 1.3. Conglomerate Mergers & Acquisitions When a firm acquires another firm with almost zero synergy with the business of the firm being acquired and one that operates in a completely different market, such combination is known as a conglomerate diversification (Brealey, Myers and Allen, 2010). 1.4. Cross-border Mergers & Acquisitions Cross border mergers and acquisitions refer to those business consolidations that happen across national boundaries. Such acquisitions involve a significant amount of cash flow between nations who enter in such agreement. Globalization and the world of internet has promoted cross border mergers and acquisitions in a big way. Economic Theory on M&A Economic value of any merger or acquisition process benefits the merged entity more that both the companies engaged in it. In other words, the benefits that accrue to the resultant firm in the process of the merger process is much more than what accrues to both firms individually taken together. To calculate the returns received by shareholders, one has to deduct the amount that the target firm shall pay to the acquiring firm from the total value created as a result of the process of acquisition. In other words: If Company 1 wants to buy Company 2 Value of PV = Gain - Cost > 0 Gain = PV12 - (PV1 + PV2) = Economic Value of M&A Here, PV is the resultant company as a process of merger and acquisition The amount that firm Company 1 shall have to pay for acquisition of Company 2 will be a function of what Company 1 realises as the value of Company 2. Such price bidding shall continue unless the winning bidder, Company 1, realises average economic profits. Returns to stakeholders of Company 2 also depend on the same bidding process wherein if the perceived price is higher than the present market price, shareholders shall benefit from abnormally high returns. To ensure that such value perception occurs in the bidding process, participation of shareholders also becomes extremely necessary (Evans, 2000). Motives of Engaging in M & A The motives behind engaging in Mergers and Acquisitions are nothing but the objectives of the business concern as a part of its business and corporate strategy. The different types of motives behind this M&A can be listed as below: 1. To discipline market and remove any inefficiencies arising out of the management. With cut throat competition in most industries, small firms find it difficult to survive in business. In order to sustain, companies often go in for mergers and acquisitions. This also strengthens their position in the industry both strategically and financially bringing them to a competitive parity. This motive increases shareholders value. 2. Expedient to capture benefits from diversification and manage market risk Many a times, companies acquire firms that have some synergy with their business in order to venture into related businesses. This is done with a twin motive of reducing cost of production of related goods and enjoying the benefits of venturing into newer markets. Diversification also helps in minimising market risk. Shareholders value created cannot be clearly determined by this motive of engaging in M&A. 3. To develop market power through consolidation in to monopolies and oligopolies. Firms that enjoy huge free cash flows can invest the money in acquiring firms within their industry. This shall not only increase the scope, market and market position but also, curb competitive by reducing the number of competitors and by sheer size and benefits enjoyed by monopolies and oligopolies. This motive increases shareholders value. 4. To synergise business into economies of scale and other related advantages. Sometimes, firms engage in horizontal mergers to expand their scope of production and strategise to compete in the market via cost leadership by benefitting from economies of scale. Such acquisitions are also taking the form of market consolidation. This motive increases shareholders value. 5. Managerial Agency Motive Such Mergers and acquisitions occur when management feels that they can do better in the merged entity than their present company. Here ownership and management is separate. It is perceived that managers shall do better if two companies come together in an M&A process. In such a case interest of one group weighs down the benefit of the company at large. This motive decreases shareholders value. The Evidence of IAG Takeover with Advantage and Disadvantages Takeover of BMI by IAG was a decision taken with a long term perspective. The key drivers that triggered this decision include. 1. Consolidation trend in the airline industry where larger firms were coming together with smaller ones, simply to gain a greater market power. Such a trend is likely to continue for the coming two decades. 2. The entire airline industry was making losses amounting to $3 billion. Mergers can eliminate marginal costs to a large extent. 3. Iberia and BA were seen as businesses with similar synergy and those that complemented each others. These were lucrative businesses that triggered their takeover. BA offered operations in North America and Asia while Iberia ensured the Latin American operations (IAG, 2011). Figure 1: Share Price movement of IAG from 31/03/2011 to 30/3/2012. (Source: IAG Shares, 2013) In the figure 1, we observe one year trend before the merger was approved on 30 March 2012; the stock price remained and fluctuated mostly above $175 but weak markets in Europe and labour unrest faced by Iberia led to a downward trend in share prices for some time. Figure 2: Share Price movement of IAG from 31/03/2012 to 06/11/2012 (Source: IAG Shares, 2013) Post 30 March 2012, when shareholders agreed to the IAG BMI merger, stock prices fell further due to the initial shock of an entire cash acquisition of a loss making airlines company. Investor confidence was gradually restored when the benefits of merger were realised and share prices started moving upwards. It is now operating on a 2 year high at around 350 GBX. IAG’s merger has had certain significant impacts on the airline industry in general. Advantages of IAG’s merger with BMI can be listed as below: 1. Airline industry was suffering from very low returns and was in constant need of capital support or general restructuring. IAG’s merger with BMI brought together advantages of economies of scale in its operations. 2. There were two types of cost benefits associated with this merger. The first is local synergy. This implies that the airline, post merger, has a greater scope of operations at the same airports it was operating earlier. The second is cost synergy in terms of scale of funds available to purchase assets further. 3. IAG’s takeover of BA and Iberia has also led to a greater market presence and larger geographical presence of operations. 4. BMI acquisition has led to IAG having more number of slots at Heathrow airport. This helped in saving a lot of material costs. Also, this deal has added on to the number of slots for IAG at Heathrow. The company plans to expand its short haul network breadth at Heathrow. 5. IAG utilised its free cash flow in acquisition of BMI and curbed competition while expanding its scope through the merger. IAG-BMI deal was an entire cash transaction. Disadvantages as an evidence of IAG takeover are listed below. 1. Mergers often lead to job cuts. IAG’s deal with BMI has caused more than 2000 people to lose their jobs (Mail Online, 2012). 2. Merger often leads to unwanted acquisition of non profit making concerns along with sick concerns that need to shut down. There are a lot of cost overruns when a cluster of firms are acquired in terms of ‘package deal’ that includes these sick firms. 3. IAG shall now have a larger management team with participation from BA as well. Maintaining these industrial relations shall be a constant prickle with IAG’s management. 4. An additional liability of BA’s pension fund comes tagged along with the BMI deal. To service this, IAG shall have to fund a shortage of £3.7 billion. 5. IAG now faces the risk of the global economic cycle. Demand and supply factors impacting globally in the airline industry shall also determine operations of IAG (Ryanair/Aer Lingus Merger Inquiry, 2013). After a difficult economic situation that the world faced in the recent times, IAG reported significant improvements in their economic performance. In 2012, they acquired BMI and integrated with BA and restructured Iberia. Despite all of this, IAG consolidated made losses to the tune of €23 million over revenues earned about €18.1 billion. This is a very good result because most cost overruns were on account of restructuring costs for Iberia. Conclusion Post merger, consolidate IAG has had tricky financials. Despite a €73 million gain over the estimated fair value in takeover of BMI, the company is running in operating losses. Also, IAG has had to borrow to the tune of €211 million owing to operating finance requirements post the merger. IAG was operating with a profit of €407 million for the year 2011. The acquisition related to BMI in 2012 had consolidated IAG making operating losses to the tune of €613 million. However, this is not the cause of worry for investors. This is because IAG has had cash outflows in acquiring firms that were loss making. IAG assures that this trend shall not last for the next year. It is believed that such costs are being incurred in laying down strong foundations and IAG targets operating profits of about €1.6 billion till 2015 (IAG consolidated Annual Report, 2012). IAG plans to retain the brands as well as products that were functional with each one of the acquired airlines. This shall retain customer loyalty and IAG shall benefit from an already established customer base. However, BMI shall be an exception where IAG’s management weigh single airline operations in London to be more beneficial than two separate brand names. Additionally, IAG plans to cut costs by engaging in making joint purchases for engineering supplies, sourcing engine work within its purview, benchmarking engineering with the global standards and co sharing of service bulletin. Airline industry is presently facing a weak demand. In this scenario, IAG takeover might face a short term slump in demand and might make fewer profits despite a huge capacity expansion. Also, fuel prices have been increasing persistently. The merger has put pressure on costs and revenues. Converting loss making entities into profitable divisions is the prime challenge for IAG presently. It is only once IAG achieves a 12% return on investment post merger with BMI, BA and Iberia, it will be allowed to go in for further consolidation plans. Reference List Booth, L. D. and Cleary, W. S., 2010. Introduction to Corporate Finance. Ontario: John Wiley & Sons Canada, Limited Brealey, R., Myers, S. and Allen, F., 2010. Principles of Corporate Finance, Concise. New York: McGraw-Hill Education Cornell, R., 2008. Why Companies Do Not Pursue Attractive Mergers and Acquisitions. New York: Cambria Press Evans, M. H., 2000. Mergers & Acquisitions. [pdf].Excellence in Financial Management. Available at: [Accessed 5 November 2013]. IAG Consolidated Annual Report. 2013. Full Year Results Announcement. [pdf].IAG. Available at: [Accessed 5 November 2013]. IAGshares. 2013. IAG Stock Chart. Available at: < http://www.iagshares.com/phoenix.zhtml?c=240949&p=irol-stockcalculator.> [Accessed 8 November 2013]. IAG. 2011. IAG – acquisition of BMI. [pdf]. IAG Available at: [Accessed 5 November 2013]. Mail Online. 2012. IAGs Takeover Of BMI Means 2,000 Jobs Grounded. [online] Available at: [Accessed 5 November 2013]. Ryanair/Aer Lingus Merger Inquiry. 2013. Summary Of Third Party Hearing With International Airlines Group Held On 19 March 2013. [pdf]. Competition Commission. Available at: [Accessed 5 November 2013]. Watson, D., and Head, A., 2013. Corporate Finance: Principles and Practice. London: Pearson Education, Limited Read More