IAG's Acquisition of BMI: Rationale and Shareholder Value

Introduction

Lufthansa is one of Europe's largest airlines, measured both by the number of passengers flown and by total revenue. Lufthansa's aviation corporate structure consists of five segments: Passenger Airline Group, Logistics, Technik, IT Services, and Catering (Appendix 1). With generated revenues of €28.7 billion and a net loss of €13 million at the end of the reporting year, the organisation recorded a loss of €285 million connected to the discontinued operations of British Midland Ltd. (BMI). This result forms the financial basis for BMI's sale to International Airlines Group (IAG). BMI, as a subsidiary of the Lufthansa Group, is a UK-based airline that operates from London Heathrow as its main hub, serving major UK cities (Regional BMI) as well as destinations in the Middle East, Africa, and Asia. Heathrow is one of the world's busiest and best-connected international airports.

International Airlines Group (IAG) is one of the largest airline groups in the world, ranking sixth globally and third in Europe by revenue and passenger numbers. IAG was formed in 2011 through a merger of British Airways and Iberia, a Spanish-registered carrier. Their motto is "Stronger Together." The combined companies offer an expanded worldwide network. Financial results have been promising: combined operating profit doubled following the merger and revenue rose by more than 10% (Appendix 3).

This report investigates the proposed acquisition, recognising and critically discussing the business justification for the deal and its likely long-term implications. The key objectives are to: identify the business rationale for the takeover from the perspectives of both Lufthansa and IAG; address the complexity of the acquisition and the motives — including managerial motives — put forward; evaluate the expected gains from the takeover; and discuss the corporate objective of generating higher cash flows for shareholders.

Rationale for Acquisition

Secondary research was conducted to address and investigate these issues. The airline groups' websites were thoroughly reviewed for financial performance data and stated reasons behind the acquisition and disposal. Academic journals and textbooks were also consulted, supplemented by recommended reading on mergers and takeovers with a UK focus and relevant articles from the financial press.

To understand the current transaction, it is useful to consider Lufthansa's earlier acquisition of BMI. In 2009, Lufthansa purchased the remaining 50% of BMI owned by Sir Michael Bishop, who effectively forced the purchase under a long-standing shareholder agreement. As the existing majority shareholder, this acquisition gave Lufthansa greater control of BMI's flight operations at London Heathrow, where BMI controlled approximately 11% of all take-off and landing slots. Unfortunately, following the acquisition, the combined BMI operation posted an operating loss of €154 million in the first nine months alone, widening from €90 million in the same period a year earlier. Lufthansa noted on 27 October 2011 that rising fuel costs were the primary driver of declining profitability, compounded by tax burdens incurred at the time of acquisition.

Rising fuel costs drove a number of carriers to seek closer ties with rivals, while others were forced to cease operations altogether. Consequently, BMI was put up for sale in November 2011. On 22 December 2011, IAG and Deutsche Lufthansa AG announced that they had reached a binding agreement for IAG to acquire British Midland Limited (BMI). The purchase price was set at £172.5 million in cash, subject to significant reductions, and Lufthansa agreed not to sell its BMI subsidiary bmibaby before the deal's completion (Buyck, 2011). As part of the agreement, Lufthansa also undertook to assume BMI's defined benefit pension scheme obligations.

A central motive for IAG was BMI's portfolio of Heathrow take-off and landing slots. According to IAG, the deal would increase their slot portfolio by 56 additional slot pairs. British Airways at the time held approximately 44% of Heathrow slots; completing the acquisition would take IAG's combined slot share (BA + IB + BMI) to around 53%. Transforming the Heathrow hub more efficiently would allow significant unit cost reductions post-acquisition by eliminating duplicated overheads, optimising aircraft utilisation by size and sector length, and realising distribution and marketing synergies.

Discussion: Mergers, Acquisitions, and Shareholder Value

Virgin Atlantic and its founder Sir Richard Branson made efforts to block the takeover of BMI, claiming the acquisition would create competition concerns for airline passengers, generate local monopolies, and drive up fares. UK takeovers involving European dimension are regulated under the Competition Policy of the European Union, set out in Article 81 of the Treaty of Rome. The sale of BMI to IAG required approval from European Union regulators. The European Commission extended its deadline to rule on the deal from an earlier date to 30 March, signalling the complexity of the competitive issues under review.

There has been a vast increase in the number of mergers and acquisitions over the last fifty years, and as a result, whether such transactions create value for shareholders has become one of the most extensively researched topics in corporate finance (Sudarsanam & Mahate, 2003). The body of research remains largely inconclusive and continues to be heavily debated. When two organisations are combined, the resulting situation is complex, with many underlying factors contributing to both success and failure. Generally, the stated goal of mergers and acquisitions is to create synergy — the combination of two organisations producing greater value than the sum of each separately.

There are, however, a variety of competing motives to consider on both sides of any deal. One study found that the target company's shareholders tended to experience financial gain while the acquiring company's shareholders fared less well (Meeks & Meeks, 2001). Research conducted with Spanish firms demonstrated even greater rewards for target company shareholders than those observed in the UK and US (Ocaña et al., 1997). Some of this disparity can be attributed to transaction costs that must be absorbed by the acquiring firm. There may also be self-serving interests at play on the part of the acquiring company's executives, whose personal financial incentives — bonuses, stock options, and the like — are often tied to the completion of major deals. It is therefore reasonable to suspect that many mergers and acquisitions have proceeded with little regard for the actual benefit to shareholders.

A further complication in analysing mergers and acquisitions is the difficulty of measuring long-run performance in dynamic markets. If all other factors could be held constant, constructing reliable performance models would be more straightforward. In practice, however, competitors respond to mergers by creating new pressures; horizontal and vertical industries can shift considerably; and investor information changes rapidly. Consequently, no model can fully account for either a strong or semi-strong version of the efficient market hypothesis (EMH) (Limmack, 1997). Nevertheless, numerous studies examining long-term shareholder value post-merger have found a negative effect on value — ranging from slight to severe — across a variety of models (Gregory, 1997).

Conclusion

Mergers and acquisitions will undoubtedly continue to be a hotly debated topic for many years to come. There is evidence to suggest that a wide range of motivations exists, often creating tension between the interests of internal stakeholders and those of shareholders. It is also inherently difficult to study these events, given that markets are dynamic and the effects of any acquisition are hard to separate from other market variables.