Betting that bigger is better, Air France and KLM Royal Dutch Airlines announced their intention to merge into Europe’s largest air carrier last week. 


The new airline would combine Europe’s number one and number seven carriers in terms of passengers, creating an airline that would be the sixth-biggest in the world (after five U.S. carriers). But the merger is fraught with peril for both shareholders and travelers, say Wharton professors and others. If done right, it could create an efficient organization with lower costs, but without the power to charge monopoly fares. If managers or regulators slip, however, the result could be both higher fares and higher costs.


“Unless you can show me these phenomenal economies of scale, I will assume that when airlines get together they are going to use their power to benefit themselves, not consumers,” says Bruce Allen, a Wharton professor of business and public policy. “If I am a shareholder I’ll say, ‘Hey, earning monopoly fares is good stuff,’ but if I’m a consumer I worry about fewer choices – and higher fares with those fewer choices.”


Pending approval by shareholders, labor unions and regulators, the merger would take effect sometime around April 2004, according to KLM spokesman Bart Kloster.


It’s Not the Size That Counts …

Why merge? Air France/KLM, like many companies involved in big mergers, is talking out of both sides of its mouth on this one.


On one hand, says Kloster, the merger will result in massive operating efficiencies as the two carriers streamline duplicate operations and cut duplicate routes. The company promises $706.4 million (€600 million) of long-term cost savings and revenue increases, according to documents cited in an analysis by Credit Suisse First Boston. (The CSFB analysis proclaims only a 30% chance the airline will achieve that goal.)


“We are going to coordinate schedules, fares, frequent flier programs, lounge access, cargo operations and revenue management. We are adjusting networks, schedules, joint product development, joint purchasing, joint staff training – everything you can do jointly we will do jointly,” Kloster says.


On the other hand, somehow, the airlines are going to do this with “limited” redundancies and without raising air fares. “We can reduce costs by combining certain operations in one aircraft where two operate now, and those reduced costs will lead to lower fares,” Kloster says.


Consumer Beware

Naturally, consumer advocates are wary that ‘efficiencies’ mean raising fares, consolidating routes and reducing choices. “To the extent that people claim there are consumer welfares created by large airline mergers, there have never been any,” says independent airline analyst Bob Mann.


For his part, Allen isn’t so sure bigger is better. He points out that the most profitable carriers right now are all small-to-medium-sized operations like JetBlue and Frontier. Profitable Southwest, meanwhile, may be America’s largest domestic carrier, but it doesn’t deal with any international routes and doesn’t operate major hubs.


“The interesting thing right now is that the successful carriers are the little guys,” he says, adding that the success of small airlines throws into doubt the benefit of economies of scale. “The low costs seem to be if you’re not that big, and if you’re not focused on a hub-and-spoke system. Is this a transitory thing? I don’t think Southwest’s low costs are transitory.”


Meanwhile, according to a report yesterday in the New York Times, the Mesa Air Group, based in Phoenix, has offered to buy Atlantic Coast Airlines for $512 million in stock. If the deal goes through, it would create the largest regional airline in the U.S. Atlantic Coast currently runs flights for United and Delta, while Mesa operates regional flights for United and America West, according to the Times.


The pressures on European airlines are slightly different than the pressures on U.S. airlines, giving the big national carriers a bit more leverage with business travelers, says James Fremantle of the Air Transport Users’ Council, a passenger watchdog in the UK. While airlines like JetBlue, Frontier and Southwest are now cutting deeply into key business routes like New York-LA and LA-San Francisco, Europe’s low fare carriers are often exiled to inconvenient secondary airports. Ryanair, Europe’s largest low-fare carrier, flies into airports that are long drives from London, Paris, Brussels and Frankfurt, greatly limiting its appeal to business travelers. That puts the new AF/KLM in a stronger position against Ryanair than American airlines are against Southwest.


“Ryanair doesn’t really compete with many other airlines,” he says.


On the other hand, European airlines also must compete with a functioning rail system – including, for instance, the Eurostar train, which recently cut its trip time from central London to central Paris to 2 hours and 40 minutes.


In any competitive environment, mergers are difficult operations to pull off, says Wharton management professor Peter Cappelli, director of the school’s Center for Human Resources. He agrees with an October 2002 BusinessWeek analysis that studied 302 major mergers between 1995 and 2001, and found that 61% of buyers destroyed their own shareholders’ wealth while overpaying shareholders of the smaller firms they were snapping up.


“The learning curve is steep in figuring out how to do mergers, so the companies that do them well are the ones that do a lot of them” rather than just expanding with one big merger, Cappelli says.


A Sweet Ride for Shareholders

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


The treaties that allow airlines to fly between countries are currently negotiated on a nation-by-nation basis. So if Air France bought KLM outright, the airlines would have to choose whether to fly the routes guaranteed to the French or to the Dutch. Meanwhile, prickly politicians in both nations are more than a little concerned about “foreign control” of a national flagship carrier.


So KLM and Air France will be operated as separate units by a new holding company, which will be 81% owned by Air France shareholders and 19% by KLM shareholders. The new company will maintain Air France’s stock exchange listing, and AF shares will transfer over to the new company on a 1-for-1 basis. KLM will join the Skyteam airline alliance, allowing the two separately-run subsidiaries to coordinate schedules and share ticketing.


Skyteam is one of the three major airline alliances. Airline alliances agree to some level of cooperation between their members when it comes to organizing schedules, ticketing and frequent flier programs. The two biggest are Star Alliance, led by United and Lufthansa, and OneWorld, led by American Airlines and British Airways. Skyteam, with Delta and Air France, has up until now been the third player. KLM, Northwest and Continental are all outside the three alliances, but now it looks like all three will join Skyteam, making it a much more powerful force.


KLM shareholders, meanwhile, will get a pretty sweet deal: 11 shares in the new company for 10 of their existing KLM shares, plus warrants to buy six and two-thirds more shares at a strike price of $23.5 (€20) any time during the next three and a half years. They’ll essentially receive a 40% premium on their KLM stock, and the deal promises an injection of $706.4 million (€600 million) of new capital into the firm.


But now things get weird. For three years, an additional class of voting, but noneconomic stock will be created and split between the Dutch government and two Dutch foundations, which together will have 51% of the voting rights over the KLM subsidiary (but not Air France or the holding company.)


Why does this expire in three years? The EU is already starting to negotiate air travel treaties that would cover the entire 15-nation union rather than work on a country-by-country basis. New treaties would make the need for partial Dutch control obsolete.


For five years, the new company offers KLM stockholders “assurances” that the two brands will remain separate and intact. And for eight years, the company guarantees to the Dutch government that the Paris and Amsterdam air hubs will be treated as a dual-hub system in a “fair” manner.


The merger wouldn’t affect KLM’s existing joint venture with Northwest Airlines for selling transatlantic flights, nor would it affect Air France’s cooperation with Delta. In fact, the two operating units would compete on transatlantic flights, according to Kloster. That’s certainly possible, Wharton professors say, though of course the merged company would make more money if the units cooperated rather than competed. Northwest hasn’t been asked to join Skyteam, though they would certainly be open to an invitation, according to Northwest spokesman Bill Mellon.


Only Air France and KLM executives know whether this chimeric corporate structure is a legal ruse or a potential operational pitfall. The difference is key to the success of this merger, says Wharton management professor Robert E. Mittelstaedt.


“The real issue is whether the complexity will be played out operationally or whether it is simply an organizational structuring issue from a legal standpoint,” he says. “If it becomes more complex operationally they are going to have difficulty achieving what they want to out of the merger, which is operational efficiency and increased marketing clout.”


To achieve competitive advantage, the company “has to simplify structures, not make them more complex,” he says.


The First of Many

A flurry of announcements has followed the AF/KLM merger. First, Alitalia executives said they wanted to join the AF/KLM system, which would turn the chimera into a hydra. Alitalia, Italy’s national carrier, which has shaky finances but owns 2% of Air France, has already joined a cargo shipping joint venture with Air France, Delta and Korean Air.


Then British Airways admitted it has been looking hungrily at Iberia, Spain’s national carrier. Swiss International Airlines, the financially pained Swiss national carrier, aligned itself with American Airlines and BA’s OneWorld partnership as rumors swirled that Lufthansa was interested in snapping it up.


The consolidation of Europe’s airlines is inevitable, Wharton professors suggest. The consolidation of the national flight treaties into EU-wide treaties eliminates the major barrier to cross-border mergers, and struggling airlines are looking at economies of scale as a way to survive.


“The number of airlines and the structure of airlines in Europe only exists the way it does because of government regulation,” Cappelli says. “In the future, you might see a couple of big ones and more small ones. You wouldn’t see the distribution you have now – a dozen midsized carriers.”


Mittelstaedt agrees. In a tough economic environment, markets will consolidate until something stops them. “In both Europe and the U.S.,” he notes, “you are going to see mergers until the regulators get nervous about the minimum number of airlines you can have and still maintain some aspect of competitive markets.”