Reason For Investment. 1 Reports Example
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Investment Decision Analysis: Air France-KLM
This paper examines the merger between two prominent airline companies- Air France and KLM, which took place in 2003. Both companies have had a long history of development and by the time of merger they were recognized industry leaders in their countries, France and the Netherlands. Examining the changing landscape of the aviation industry on one hand, and the deregulation and creation of the single European aviation market on the other hand the paper finds that then existing market conditions favored consolidation in the industry, because national carriers were legacy of the old national division.
Reviewing the details of the transaction, the paper finds that though the deal was structured as a merger legally, in actual fact it was an acquisition by Air France of the Dutch carrier. A new entity Air France-KLM was formed on the basis of Air France where former shareholders of KLM received about 20% of shares. The merger prospectus outlined specific cost savings and synergies which would accrue to the shareholders of the new company as a result of merger.
The paper concludes that the merger could be deemed successful, based on operating results achieved in the three year period following the merger.
Apart from the investment analysis, the paper reviews efficient market hypothesis and the modern challenges to it, in particular, the behavioral finance. The paper finds that behavioral finance may have better explanatory power for market bubbles, as opposed to classical efficient markets theory.
Success or failure of the investment 2
Important developments in finance.. 3
Air France was established on 7 October 1933, through a merger of seven French aviation companies to operate extensive networks of flights across Europe and North Africa. The fast development of the company was interrupted by the war, during which the company’s Headquarters moved to Morocco. In 1945 Air France was nationalized along with the whole French aviation industry. It has become a National Company, that is a state-owned corporation controlled by the French government. Over the years, the main activities of Air France remained the same. The airline provided worldwide passenger and cargo transport, air fleet maintenance.
The period after the war saw rapid development of Air France which operated on a global scale having one of the largest air fleets in the world. From the very beginning and until now the company has had a particular savor for using the latest up-to-date technology. For example, Air France was one of the first airlines which started using jets. It was Air France which acquired first Boeings in the late 1950 which eventually led to cutting in half of the flight time between New York and Paris. 1960s and 1970s saw increasing international competition in aviation industry and the share of international flights in Air France traffic exceeded 90% in the late 1960s. 1980s saw the company’s 50th birthday with over 30 thoudsand employees, a fleet of about 100 aircrafts and a network with 150 destinations making it ranking 4th worldwide for the number of passengers. This development up until 1990s could be described as expansion stage in Air France development. Starting from 1990s the company along with the industry entered into consolidation stage. After deregulation of European aviation industry in early 1990s Air France successfully completed its IPO, with over 2 million shareholders. The company has actively sought partnerships and alliances with other airlines. In 2000 along three other major airlines, Air France launched SkyTeam, a truly global alliance, with the objective to meet the highest expectations of millions of customers all the world over. But the major move in consolidation came from its merger with KLM in 2003.
Reason for investment
In late 1990s and early 2000s as mentioned above since 1990s the European airline industry entered into consolidation stage. Historically European aviation industry was fragmented with each country having its own national carrier. This all was to change with the creation of the single European market and also with the coming up of an open sky agreement between the EU and the US, whereby European airlines were allowed to fly to any destination in the US at any fare and at any time (Palepu et al, 2010). At the same time this period of time saw the profit margins of the European carriers falling because due to previous regulations and government support many companies could operate even if they were loss making. These factors caused the players to seek deeper forms of cooperation to realize economies of scale and synergies. In the meantime KLM, a flag Dutch carrier was struggling with shrinking sales and losses which were attributable to adverse market conditions. And to get over the deteriorating industry environment, tt was also in search for a strategic partner Against that backdrop, the specific reasons which made that merger a success were as follows (Palepu et at, 2010, p. 496):
Two prominent brands together would strengthen the position of the joint company in the oversupplied market
Two operating hubs (Paris CDG and Amsterdam Schipol) would provide strong basis for development and the company would be able to offer the customers a global network
Networks of both companies complement each other with only few overlaps, as Air France is strongly positioned in the Southern Europe and KLM has focused on Northern and North Eastern Europe.
Strengthened position in the cargo segment for the joint company
Strong complementary capabilities and expertise in many areas such as aircraft maintenance.
The arguments discussed above show that there appears to be an economically motivated case for the merger of the two companies. A number of empirical studies argue that acquirer often overpays for its investment (Palepu et al, 2010). In monetary terms, based on the closing prices as of September 29, 2003 KLM shareholders received the consideration in the value of EUR 16,74 per share which was at a premium of 40% over KLM shares closing price on that day. Total acquisition price paid to the former KLM shareholders is valued at EUR 831 mln (as per annual report 2005-06, p. 151).
Legally it was a merger whereby, in exchange for their shares KLM shareholders were to receive shares and warrants of the new Air France-KLM shares in the following proportion: 10 KLM shares are exchanged for 11 Air France-KLM shares and 10 Air France-KLM warrants. Despite the fact that the transaction had a form of a merger, in actual fact it looked more like an acquisition of KLM by Air France, which was further confirmed by its new governance structure (dominated by French) and accounting treatment thereof as acquisition (Palepu et al, 2010).
In the case at hand a new listed holding company Air France-KLM has been created which owned 100% of the shares of the private operating companies, based in France and Netherlands.
Success or failure of the investment
The main economic rationale for the investment was to achieve profitable growth and make use of the synergies which the merger was supposed to unlock. The operating results subsequent to the merger showed strong performance of the joint companies. E.g. in 2005-2007 operating income increased from 0,9 billion euro to over 1,4 billion euro. These results have confirmed the success of the merger, both operationally and financially. The share price also moved favorably for the investors rising from EUR 11 in 2003 to over EUR 30 in 2007. 2008 saw Air France-KLM to become the largest airline company in the world in terms of total revenues (annual report 2008-09).
The joint company has become the world’s largest airline company by revenue and one of the leaders in its three important operating segments: Passengers, Cargo and Maintenance, giving it the potential to realize strong synergies. This was facilitated by the complementary nature of the networks. As such, The group appears to have realized considerable synergies, e.g. in 2007 according to its annual report the amount of unlocked synergies in passenger segment was EUR 342 mln with overall synergies achieved that year estimated at EUR 500 million.
The new company is run by the joint team of French and Dutch management. As their relationship has become not a simple alliance but deeper form of integration, its success depends on the ability to cooperate in spite of inevitable conflicts in this partnership. It should be noted, that former KLM and AlItalia potential merger fell through partly due to cultural incompatibility between the Dutch and the Italian, the French and the Dutch cooperation appears to be working more than ten years after their merger.
Looking at the investment from accounting perspective, it is interesting to note that the IFRS statements show the negative goodwill, meaning that the fair value of the KLM’s net assets were in excess of the purchase price paid to the shareholders. This proves to some extent the value addition for Air France shareholders of the acquisition they made. Looking further ahead into post-merger period, Gudmundsson (2014) argues that, although the joint company Air France-KLM had impressive performance in terms of its financial results following three years after the merger, the company saw negative results later on, with losses over EUR 3.2 billion. The share prices also collapsed during the global financial crisis of 2008-2009. However one should be very careful in analysis of the company performance per se as the poor results could be attributed to the adverse market conditions.
Overall, it appears to be a well thought and quite successful deal for both companies.
Important development in Finance
The modern science of finance is based on the efficient market hypothesis(Ross et al, 2010) which says that “because information is reflected in prices immediately, investors should only expect to obtain a normal rate of return” (p. 431). The fallout is that the securities are bought and sold at fair prices. The foundations of the market efficiency are rationality of investors and independent deviations from rationality. The latter point is important as it assumes the offsetting of irrationalities at all times. However, there are some obvious problems with that theory and in particular, how to explain market bubbles assuming the efficient markets. Modern developments in finance have challenged these assumptions and market efficiency hypothesis itself. One of the modern developments is behavioral finance (p. 443) which challenges rationality and independent variations from rationality. It argues that at least some investors are irrational and that people have representativeness and conservatism biases. Representativeness bias as applied to investing means that many people would deviate from rationality and buy certain shares which have become popular. This is explained by certain psychological traits and could explain market bubbles. The second bias is conservatism and it refers to people being entrenched into their beliefs, have difficulties in adjusting to new information. Indeed, behavioral views can have better explanatory power for such events as recent markets collapse which the world saw in 2008-2009.
This paper reviewed the merger between two prominent airlines- Air France and KLM. The ongoing consolidation of the airline industry following creation of the single EU market for aviation has made smaller airlines look actively for partnerships with larger airlines. This was the reason for both companies to join forces by creating one company with a simple structure: “one Group and two airlines” (Gudmundsson, 2014). Operating results and synergies realized within three years following the merger have proven this acquisition by Air France a success.
The latest developments in Finance have brought into question the efficient market hypothesis, which underlies the contemporary finance theory. New theories, such as behavioral finance based on psychological studies appear to provide useful insight into market operations.
Air France-KLM (2006) 2005-06 reference document [Online]. Available at http://www.airfranceklm.com/sites/default/files/publications/reference-document_2005-06_en.pdf [Accessed: 12 February 2015].
Gudmundsson, S.V. (2014) ‘Mergers vs. Alliances: The Air France-KLM Story [Online]. Available at www.researchgate.net [Accessed: 12 February 2015].
Palepu, K., Healy, P. & Peek, E. (2010) Business Analysis and Valuation (IFRS Edition), 2nd ed. United Kingdom: Cengage Learning EMEA.
Ross, S.A., Westerfield, R.W. & Jaffe, J. (2010) Corporate Finance. 9th ed. New York, NY: McGraw-Hill Irwin
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