Mergers in the Air? Microsoft/Yahoo and Delta/Northwest

The ongoing takeover battle between Microsoft and Yahoo has taken several surprising turns over the past few weeks. After rejecting Microsoft’s unsolicited $44.6 billion offer in late February, Yahoo has announced a two-week ad testing program with its main search rival, Google, and has reportedly entertained a possible merger with Time Warner’s AOL. Meanwhile, Microsoft was rumored to be considering News Corp. as a possible ally in acquiring Yahoo. While spectators wait for the next twist in this saga, another headline-making deal has been announced: a merger between Delta and Northwest Airlines to become the world’s largest airline. Knowledge@Wharton spoke with Wharton management professor Saikat Chaudhuri and Wharton legal studies and business ethics professor Kevin Werbach to find out whether these deals make sense and for whom.

A transcript of this interview is available below.

 

Knowledge@Wharton: Microsoft is basically giving Yahoo three weeks to accept its current offer or face a proxy battle. That’s a very aggressive stance. What do you think of this strategy? Saikat, let’s start with you.

Chaudhuri: Well, you know, I think that they’ve waited patiently for quite some time to see whether Yahoo would come to the negotiating table — and now they want to move things forward, because this can’t continue endlessly. Yahoo hasn’t indicated any positive inclination so far to come and negotiate. So, [Microsoft is] just putting forward this step in order to make sure that there is some resolution either way.

Werbach: I would tend to agree with that. I don’t think that Microsoft can sit around forever and wait for Yahoo’s feelings to change, or wait for something in the marketplace to change. This is a major strategic deal for Microsoft, and I think that at some point they need to signal both to Yahoo and its shareholders in the market that that’s the way they feel about it and that they’re going to go forward, if they can, and try and close the deal.

Knowledge@Wharton: By taking this approach, does Microsoft risk losing one of Yahoo’s key assets — that is, losing its talented employee base?

Chaudhuri: I think that’s why they were so patient for so long and they were, perhaps, overly cautious in order to allow for Yahoo employees to see that they’re not taking a very aggressive approach. I think that after a few months pass, everyone expects some movement to be there. I’m also not sure whether it’s going to have a negative impact. I mean, you’re absolutely right in that the sources of value are a lot in the people here, as well as the customers that Yahoo has.

But, Yahoo hasn’t performed up to expectations for some time now. I would imagine that there certainly is a very loyal group of supporters who will stick with Jerry Yang, no matter what. But then, there is also a group which is perhaps a little demoralized, given that they don’t see much movement, and they may be willing to move forward on the deal as well and perhaps go forward with Microsoft. So, I think that it’s the right move from that point of view.

Werbach: Yahoo is going to lose some important employees, not matter what. I mean, these are people who don’t want to work for Microsoft. They are people who think of Microsoft as “The Evil Empire.” And, that has nothing to do with the nature of the acquisition, whether it’s hostile or friendly. So, I think that frankly those people will leave any way. At this point, if they want to close the deal, they need to go on with it.

Knowledge@Wharton: Kevin, how much, at this point, does it seem that pushing this deal through is a matter of ego for Steve Ballmer?

Werbach: I wouldn’t say ego; I would say that it’s a very important deal personally for Steve Ballmer. He’s not going to be running this company forever. Bill Gates has already stepped away recently from basically active involvement at Microsoft. With Ballmer, this is his last chance for a real signature move. He understands that the industry is changing. I don’t think he had to make this deal; but I think that once he decided that this was the direction that they were going to go, it’s his stamp on it. So, it’s not just a matter of ego; it’s a matter of this is his last signature move in terms of how he is going to leave Microsoft — whether it’s to Ray Ozzie or to whoever else comes after that. 

Chaudhuri: I agree with that, and I think that if anything Microsoft’s been criticized for not taking more aggressive steps in the past, to compete with Google and improve their presence on the internet and the web space and so forth. Now, they have decided that they are going to do a very credible and serious move in that direction. And so, they are just moving it towards its logical conclusion. I think it’s about that. It’s a very rational move, in my opinion, for them to do something. This is because if you look at it, both Yahoo and Microsoft combined could actually be some force against Google on the internet, especially in the advertising space — and alone they have been struggling for quite a few years now.

Werbach: Yeah, that’s an important question in terms of just how successful the deal will be. But, in terms of Microsoft’s approach, they are a very aggressive, very paranoid but very calculating company. They don’t do things just on emotions. They do things because they really feel like it’s in their interest.

Knowledge@Wharton: What do you think about Yahoo’s highly publicized test of using Google’s AdSense service on its site? Well, first of all, can you explain what the actual test is, what they are doing with it and what they hope to get from it?

Chaudhuri: I’ll let that first part go to Kevin. 

Werbach: Sure. Both Yahoo and Google have services that monetize searching. They match advertisers who pay to be matched with people who are searching for different things on the Internet. Google’s search ad matching technology just works better than Yahoo’s or anyone else’s. It converts more and advertisers like it better.

Yahoo did sort of a crash course project called Panama to improve their service. It didn’t really move the needle very much. So, this is partly just trying out a different technology that everyone agrees is the Gold Standard in the industry. But, obviously there is more to it than that in this current environment. Google is the competitor that clearly Microsoft is trying to buy Yahoo, in part, to compete against. So, it’s definitely also a shot across the bow.

Chaudhuri: Yahoo has been trying to search for other alternative options, in the last couple of months, ever since this offer came up. They are still searching for that option. I think that this is a tactic in that direction. Nothing has emerged very concretely — no “White Knight” has emerged and the alliances seem unlikely. But, nonetheless, I think that this is a credible signal that they are exploring other opportunities and are perhaps even hoping that this might increase the offer a little bit from Microsoft — to make a convincing case.

Knowledge@Wharton: Let’s look at some of the other deals that are reportedly under consideration. Yahoo and Time Warner were reportedly talking about folding AOL’s internet operations into Yahoo. Would that make sense?

Chaudhuri: I don’t think that it would be a more attractive option. I think that it’s a way for AOL to survive in that space, but also for Yahoo to stay independent. If you think about options where Yahoo would be able to remain independent — that’s something that can be taken fairly seriously and looks quite good. But, if you don’t agree with the basic premise that Yahoo can survive on its own, then, I think the Microsoft offer looks much more attractive.

Werbach: Yahoo’s view all along has been that Microsoft undervalues the company and it still has a lot of legs as an independent business. So, I think that Saikat is right. AOL and some of the other rumored deals — getting News Corp. involved, even the partnership with Google — are all ways that don’t involve submerging Yahoo into a larger entity as the Microsoft deal would.

Knowledge@Wharton: Can we talk a little bit about this rumor of Microsoft teaming up with News Corp.? What’s that all about?

Chaudhuri: It’s some sort of joint offer or joint bid in the works perhaps to sweeten [the deal] for Yahoo, or maybe to help with the financing of the deal. I think honestly that it would be very complicated — not, perhaps, to pull off from the point of view of striking a deal, though that is one consideration; but especially, what would the post-acquisition arrangement look like?

I am just not comfortable with the idea from that point of view. You know, how would News Corp. then think about this? Who would own which piece and manage and influence what piece? I think it’s a constellation which was thought about to perhaps make it more attractive or perhaps to help increase the bid. But, it would be very complicated to implement.

Werbach: Rupert Murdoch has a tremendous track record of basically injecting his company in a very effective and strategic way into every aspect of the media landscape and every key transition. And so, they are very savvy and very smart. They have some really important assets. I’m also not clear that it would make sense for either Microsoft or Yahoo. But, we have to remember that we are at sort of the “mating dance of the dinosaurs” here. These are all the big players, seeing assets in play now that are valuable to them in the future of the digital economy. And so, pretty much everyone is mobilizing to get into this fight.

Knowledge@Wharton: Would the complexity of these deals be a severe handicap to the merger should it go through?

Chaudhuri: Surely it’s a large deal with established players. There is some hostility between them and they’re competitors right now. But, if they can unite and rally around the common objective of successfully competing against Google, that might be a strong unifying force. If that need becomes clear to both sides — and I think this is very clear to Microsoft — but if that need becomes clear to the Yahoo employees as well, and they decide and can be convinced that joining forces with Microsoft would be indeed the right answer, I think that some of those challenges can be overcome.

And then, of course, you have to figure out common processes and post-merger organizational structures. In that, I actually see an opportunity because Microsoft could actually open up a strong presence in Silicon Valley should they choose. For instance, instead of running the internet advertising operations out of Redmond, they could conceive of some sort of reverse integration where MSN would essentially be folded into Yahoo with a strong and a large office presence in the Silicon Valley area. That would also help in some ways to alleviate the concerns that people have about “Oh, here’s that big giant, big and bad kind of player, that brings everybody to Redmond and stifles ideas.” If that’s the perception that some have, they could counter that as well both internally and externally. So, I do see some opportunities there as well.

Werbach: I don’t really think that any of that ultimately matters. I think that both of these companies face a fundamental challenge which is the industry is going through a transition and they are stuck on the outside chair in musical chairs. Microsoft is a software company. Yahoo is basically an online media company. And, the world is moving to web-based services, basically the place where Google right now is at the center and dominating.

They are both smart companies, they have smart executives and they understand that. That is, I think, the part of the reason why this deal is being bandied about. I don’t think that the deal solves that problem. I think that it puts two companies together that have some complimentary assets. And, absolutely, there would be smarter ways to do the integration, to take advantage of it. But fundamentally, no matter how simple or complex it is, I don’t see how this deal gets the merged company to a point where they can really compete effectively in this new world.

Knowledge@Wharton: So, if you were Steve Ballmer, what would you do?

Werbach: Well, I would certainly call the Wharton School first and ask for our advice. [Laughs] To the extent that he has made this call, who am I to second guess Steve Ballmer? He’s a brilliant and extraordinary business executive. If they’ve gotten to this point of feeling that they need a Yahoo — that they’ve taken a look internally and said, “We are not going to make this transition from being a software company that builds packaged software and operating systems into a web-based services company,” because they’ve really been trying; if the conclusion internally is “We couldn’t get there alone” — then, by all means, go for it. Yahoo is probably their best chance to actually change things; even if outsiders like me are pessimistic, they’ll get there. Go for it, and give it a shot.

Chaudhuri: I agree. I think that Microsoft needs to do something in order to strengthen its presence in that area. This represents a fantastic opportunity. They’ve started it; so for reputation’s sake, and given that this is quite a rational move for them, I think that they should move toward its logical conclusion.

Knowledge@Wharton: So, let’s flip the question. If you were Jerry Yang, what would you do in this case?

Chaudhuri: Try and squeeze out the best offer possible. I think that he is doing some good tactical moves. But, I would start sending a few feelers out because at some point, your own stakeholders — and I’m saying not just shareholders, but also other stakeholders, such as some employees — might begin to question why you’re not trying to at least extract a good offer in the absence of alternative offers. And also [there is] the fact that this does represent a good premium and a very good opportunity. I would start doing that, but of course you play the tactical game in order to squeeze out the best value that you can and move towards whatever valuation that they think is fair for their side.

Werbach: I think that is right. He’s in a very tough position. He co-founded this company, it’s an extraordinary entrepreneurial success story — and yet he’s got to see the writing on the wall. Yahoo is still a growing and profitable company, with a lot of incredibly successful businesses, tremendous numbers of users and so forth. I think there’s been enough time, over the past few years, to suggest that it’s going to be hard for them to just pull out of the slide that they’re in on their own.

And so it’s a difficult thing, I think, both personally and as a leader, but I think that he needs to make that transition — whatever the outcome is, whether it’s Microsoft or something else that helps the organization understand that.

Knowledge@Wharton: How do you think this is going to play out in the end?

Werbach: I think Microsoft wins in the end. They’re relentless and again, I can’t help but think that haven’t come this far without having made the decision that this is a bet-the-company deal. And, if that’s the case, they’re not going to give up until they win.

Chaudhuri: I agree. I think that that’s going to be the outcome that Microsoft buys Yahoo.

Knowledge@Wharton: Let’s turn to another merger that’s making headlines — the one between Delta and Northwest Airlines. Does this merger make sense?

Chaudhuri: I’m happy to see it finally materialize. And the reason is that these airlines have been struggling for some time, and with the oil prices being as high as they are, they have to try and extract synergies on the cost side in order to go anywhere. I don’t see oil prices coming down substantially, and so I think that this is a new reality that they have to deal with.

The reason why I like this particular solution with Northwest and Delta is also because it’s clean, from the point of view that it’s within an alliance and the complementarities are fantastic. Delta has a strong franchise in Latin America and more recently they’ve built it up in the Atlantic routes. Northwest is strong in the Pacific routes. So, from that point of view, I think that they fit well together. I think that this will also lead to further consolidation. But, we can talk about that a little bit later.

Werbach: I don’t have much to add to that.  I’m not an expert on the airline industry per se. But, I will say that it is another industry where scale matters, probably even more so than in technology. Scale is very important in the Microsoft Yahoo deal, but with the airlines there are just such extraordinarily high fixed costs, as Saikat was saying — the fuel, the planes and so forth — that typically an effective merger can actually create some economies of scale.

Knowledge@Wharton: So, that said, can we expect other mergers from the big carriers?

Chaudhuri: I think so. I think that what will happen now is that other airlines are not going to sit back and watch them be the largest carrier or watch them potentially reap rewards. Now, of course, these integrations are going to be complex because unions are involved and so forth. But, I think the next one that probably might occur is something like United with Continental for similar reasons.

Continental has built a bit of an Atlantic franchise. They have an east coast presence, they are in Latin America. United is stronger on the west coast and has done some more on the pacific routes. And in that case, it might work nicely because Continental could then come into Star Lines because, unlike Delta, they’re not a founding member of SkyTeam. So, they could come into Star Lines, which would work very well. They would be welcomed because Star Lines, especially Lufthansaand the others, have really been looking for a New York area hub. So that would work.

And then the question becomes: If that were to happen — this is all hypothetical — then will American Airlines sit back, having been the largest carrier, or will they try and do some kind of smaller deal — like US Airways perhaps? But, a lot of this is also subject to regulatory approval. It’s not as though these are going to sail through automatically. It will take 6 to 8 months to get them approved. And, there will be some redistribution of hubs and assets and routes and so forth. We kind of will have to see it collectively. I think that what they will do is basically a few of these will be announced and then it will all be evaluated together to try and optimize on a macro level.

Werbach: Yes, the antitrust review is going to be very significant because this is already an industry that has consolidated a lot. And, I agree, it is potentially going to consolidate a lot more. And that involves law, but also politics, and so it will depend on who is in the White House next year and what the posture is of their Justice Department and which deal goes first. So, a lot of that is hard to read right now. Obviously, we have a presidential election coming up, where the outcome will have a significant affect here.

It’s hard to see all of the deals going through. On the other hand, to the extent that a major deal like the Northwest and Delta one goes through — and again, I’m not an expert per se in this area, but it sounds like the expectation is that it would — then it’s harder, every step down the road, for the Justice Department to say, “This next deal is that much worse than the previous one.” If you look back, it wasn’t that long ago that we’ve had airline mergers scuttled because of regulatory review. 

Knowledge@Wharton: Now, this merger announcement came after four of the smaller airlines shut down. Are we going to see a lot more fall-out among the smaller discount carriers?

Chaudhuri: It’s hard to say what their posturing will be. I do think though that everybody is struggling a little bit, so they’ll have to consider these things. But, I primarily see the cost bases of the full service carriers being the ones which are most challenging. And they are the ones who are facing competition from the low cost airlines. Most of the activity will be there, but yes, they can start considering options for themselves amongst the low cost carriers. But, there aren’t too many opportunities left there — as you are alluding to, some of them have folded. So, it’s hard for me to predict what will happen on that front.

Werbach: I’m thankful that I’m not in the airline industry. You can make a lot of money in good times, but it is really challenging and it is hard to see it getting less challenging going forward.

Knowledge@Wharton: Is fuel the major impediment right now, would you say? Or are there other issues that would drive consolidation, or some of these closings?

Chaudhuri: Labor costs were the other issue; but I think that after everyone went through bankruptcy protection, they worked on that angle. Right now, fuel has become the largest cost for these airlines. 

Knowledge@Wharton: How do you think this merger will affect consumers?

Werbach: It’s hard to say. I don’t think that most consumers, at least in America, are terribly happy with the airline industry. And so it’s hard to see the consolidation, per se, making them happier, except to the extent that the merged company decides to try to invest more in improving service quality — they use some of those efficiencies that they would get from the merger to improve customer service or to the extent either they or one of the other major carriers decides to make that a point of emphasis.

Not speaking as a business school professor, but as just a person who flies on airlines, it certainly seems like a lot of people would pay another $10 or $20 or even $50 on a trans-continental round-trip ticket for just the level of food and service and leg room that they got ten or fifteen years ago. And, it seems like there should be an opportunity there, but there’s a lot of complexity of course within the industry that makes it hard to get there.

Chaudhuri: I do think so as well. Hopefully, they will do some of that. Otherwise, the immediate fears, of course, are higher prices if there is further consolidation in the industry. If we look at it from the point of view that we want airlines to survive, then for the consumer, it’s good for them to merge. This is so they can at least try and get some of these efficiencies.

I think that in recent times — and by that I mean the last few months — there has been an effort again to try and increase, or at least give some thought to better service on board, by bringing some pillows back and the like, you know? We all fly often from the east coast to the west coast, overnight and during the day. And, we would like at least a hot meal on that plane. I wouldn’t mind shelling out another $10, $20 or perhaps $30 or $40 for it, as irrational as that may sound.

But I think the trouble — and what Kevin is really alluding to — is that the airlines have dissected the market into two groups, and I think that there is a third group that they are forgetting. They have thought about either the first class traveler or they’ve thought about the extremely price conscious traveler on the other end. They haven’t thought about the medium or high-end economy travelers, I will call them, who are willing to pay a little more. They won’t just go with the cheapest option because it’s $5 or $10 cheaper. I think that’s certainly an area — whether through a premium economy or through introducing some service levels again that you would have previously — where I can only hope, like Kevin says, that some of these efficiencies will then turn into positive service improvements.

Knowledge@Wharton: Given the current economy, how would you, if you were an airline, go about making a profit?

Werbach: I think that there is an opportunity in what we were saying. And, of course it depends on what size airline you are and what cost structure you have. Southwest, for a number of years, profited when all its competitors didn’t, simply because they executed better in lots of ways. Some of it was structural, some of it was just decisions that they made about hedging fuel prices and so forth.

But, I would agree, I think the opportunity is that if you can’t be the absolute low cost company — and that’s just really hard to do and to pull off consistently — find a way to get people to have brand loyalty, which hardly anyone has in the airline industry.

And, again to go back to the technology field, Amazon.com is not the cheapest place to buy books. It hasn’t been for a very long time. It’s cheaper than a bookstore, but there are plenty of online book sellers that undercut Amazon’s price. But people still go to Amazon because they have a good experience — they have loyalty, and Amazon has done a lot to cultivate that. I think that if an airline executed that strategy, they would have a much more enduring competitive advantage than one that just focused on just a little bit better yield management, or a little bit better cost cutting.

Chaudhuri: I think the tremendous opportunity now is if that you have these consolidated networks, by combing airlines, you truly have global coverage. And with that, we all know that the margins are higher in the international sectors, both trans Atlantic and trans Pacific.

So, if one can position oneself as a good global carrier with many options to connect to smaller places and then harmonize the service a little bit — so that somebody who travels on a trans Atlantic flight and enjoys somewhat of a decent quality of service doesn’t get shocked when they land at a hub and fly another 4 hours to go to San Francisco, for instance, from the East Coast, with a completely different level of service — they can reposition themselves. They could [then] tap not only into the complete leisure traveler who travels once or twice a year, but [also] the global business traveler — and we know that a lot of it is not just in business class, but it’s an economy class, given the state of the economy now a days. And, certainly, technology companies and start-ups make use of that. I think that is the positioning that can be done, especially as part of these larger networks and global alliances which the low cost carriers don’t have.

So, I agree. I think, fundamentally, that they need to orient their strategy, or re-orient their strategy, not just to try and emulate and copy what the low cost carriers are doing, but to really try and find a niche for themselves and to position themselves accordingly.

Werbach: Yes, and one other piece to this is getting back to government. Part of the reason why flying is so much worse an experience now is the post-9/11 security climate, and certainly for people coming in from oversees, the difficulty of arriving in the Unites States. Certainly, security is critically important and it’s obviously important for the government and for the private companies to ensure that terrorism is prevented and so forth.

There’s a great deal that we do that makes fliers lives worse that doesn’t make security any better, and in some ways, it makes it worse. Again, with an election coming up — this is not a partisan thing — but if someone comes into the White House who makes this an issue, to ensure that we appropriately find ways to be secure while not stepping on the toes of people flying, I think that that will help the carriers as well.

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