Delta and Northwest Airlines Merger: Rationale and Synergies

Introduction

Mergers and acquisitions form a very integral part of the contemporary corporate landscape. Kolker (2010) points out that the initial six months of 2010 witnessed the total value of global acquisitions increase by 2.7% to a monetary value of $915 billion — an increase over the same period in 2009. However, 2010 was off to a rather slow start compared to 2006, which recorded an excess of $3.8 trillion in acquisition-related transactions (Yeary, 2007). It is worth noting that it is never merely the volume of deals that matters, but their size. On average, twelve transactions valued at more than $1 billion were announced each week of 2006 (Yeary, 2007).

The concept of acquisitions is justified on the expectation of generating incremental shareholder value (Chatterjee, Lubatkin, Schweiger, and Weber, 1990; KPMG, 1999). A substantial body of literature has been dedicated to the potential benefits associated with acquisitions. It is worth noting that the terms merger and acquisition are distinct, though the strategies underlying each concept are treated as similar by several researchers. Seth (1993), for example, postulated that market power, economies of scope, economies of scale, risk diversification, and co-insurance are among the benefits associated with mergers and acquisitions. Tetenbaum (1999) also argued that acquisitions can be justified on the basis of their potential to improve efficiencies while cutting costs (p. 24). Nguyen and Kleiner (2003) suggested that acquisitions afford acquirers the prospect of increased market share, reduced cost structures, and a widened range of service offerings. Appelbaum, Lefrancois, Tonna, and Shapiro (2007) further postulated that acquisitions are an outcome of heightened competition — both domestic and international — and represent firms' efforts to "preserve their business model and improve profits" (p. 128).

A large body of literature has been dedicated to the failures and successes of acquisitions, most of it focused on the concept of strategic acquisitions (Appelbaum, Lefrancois, Tonna, and Shapiro, 2007; Bijlsma-Frankema, 2001; Chatterjee, Lubatkin, Schweiger, and Weber, 1992; Covin, Kolenko, Sightler, and Tudor, 1997; Datta, 1991; Fubini, Price, and Zollo, 2006; Jemison and Sitkin, 1986; Hyde and Paterson, 2002; Kiessling and Harvey, 2006; Seth, 1993; Tetenbaum, 1999; Marks, 1997; Nguyen and Kleiner, 2003; Olie, 1994; Vaara, 2002; Vasilaki and O'Regan, 2008; Waldman and Javidan, 2009).

Literature Review

When two different corporations combine to form one business, the situation is referred to as a business merger. A merger is generally considered worthwhile when the two businesses dissolve and combine their assets to create a new third entity (Ramanujan, 2006). Mergers and acquisitions occur in the business world primarily to bring new assets into a business (Freeland, 2007), and usually result in the formation of a new corporation. The majority of mergers arise from friendly agreements and are not forced (Gaughan, n.d.). Shareholders of the two merging companies subsequently come together to enjoy the benefits of the amplified profits of the newly formed entity (Peterson, 2006).

The Rationale Behind the Delta–Northwest Merger

Acquisitions, by contrast, refer to a takeover — a situation in which one company purchases another. Typically, a larger company acquires a smaller one. There are two main forms of acquisition: one occurs when a firm buys shares directly from the shareholders of the firm being acquired, and the other occurs when the firm purchases only specified assets belonging to a company.

There are numerous benefits for which mergers and acquisitions are conducted in the business world. One of the most common reasons firms merge, acquire, or take over another company is to maximize profit. Through mergers and acquisitions, a company is capable of consolidating duplicate departments, thereby cutting costs and maximizing the use of previously duplicated resources. When Delta Airlines merged with Northwest Airlines, the Air Line Pilots Association strongly supported the deal, stating that the merged Delta would be more stable and more financially durable, and would benefit not only employees but also the community at large and the traveling public. These advantages were expected to flow directly from profit maximization by the newly formed firm. The merger resulted in the creation of a very large carrier — indeed, it was described as the largest airline in the world by revenue passenger kilometers.

Mergers and acquisitions can also yield tax savings. For instance, a profitable firm can acquire a loss-making firm, thereby reducing its tax liability. Mergers and acquisitions are also pursued to gain a larger market share; the merging firms can capture a wider market and potentially create a monopoly, enabling them to set prices and terms. When cross-border mergers occur, the local currency of the acquired firm can appreciate relative to that of the acquiring company. When Delta Airlines merged with Northeast Airlines in 1972, it became one of the key carriers in Boston and New York. When it merged with Western Airlines in 1987, it became the fourth-largest airline in the United States and the fifth-largest in the world, extending its operations to other continents including Asia. After the Delta–Northwest merger, the combined firm's market share stood at 19.9% in the United States alone.

Benefits of Mergers and Acquisitions

The overriding rationale applied to explain merger and acquisition activity is that the acquiring firm seeks to improve its financial performance. Among the key benefits are economies of scale — the cost advantages a firm gains from large-scale operations — which allow the newly formed company to minimize fixed costs. Economy of scope is a related advantage, referring to efficiencies linked primarily to demand-side variations such as expanding or contracting the marketing scope and distributing a wider range of products.

Enlarged revenue and market share also result from mergers and acquisitions. When two or more firms merge, they capture a larger market and may be in a position to set their own prices. When Delta Airlines merged with Northwest Airlines, the newly formed Delta had a total of 12,000 pilots and was projected to generate US$35 billion annually. Revenue increases after a merger arise for several reasons: the enlarged market increases profitability; the combined firm may create a monopoly and set prices for its goods and services; improved marketing strategies generate more sales; and the firm enters new markets, attracting more customers (Boemeh, n.d.).

Synergy also results from mergers and acquisitions — for instance, managerial economies such as greater opportunities for managerial specialization, as well as purchasing economies.

Resource transfer is enhanced when two firms merge. Resources previously held by the two firms are redistributed and used more effectively by the new entity, improving overall profitability. Scarce resources can be combined to achieve greater success, creating value by overcoming information asymmetry (King et al., 2008). Mergers and acquisitions benefit the newly established company through cost savings in airport operations, information technology, and supply chain economics. The resulting company cuts fixed costs by eliminating duplicate departments and operations, lowering overall costs relative to the revenue stream and thereby expanding profit margins (Boemeh, n.d.). When Delta Airlines merged with Northwest Airlines, the merger helped both firms save costs by combining airport operations and sharing information technology, which was expected to lower prices for customers.

There are several additional ways in which cost savings are achieved through mergers. These include economies of vertical integration and the elimination of management inefficiencies, with the resources of the merging companies complementing each other. In an efficient market, incompetent management teams will quickly be replaced by more capable ones. When a firm is not being managed in line with shareholder wealth maximization, another firm may seize the opportunity to add value by merging with the inefficient firm (Jensen and Ruback, 1983). The merged Delta–Northwest entity was said to generate approximately US$1 billion in cost efficiencies annually.

When two companies merge, taxes are also reduced. Net operating losses are transferred to the profitable firm; unused debt capacity is maximally utilized; and reinvesting surplus funds in tax-free mergers becomes an alternative to paying dividends or repurchasing stock (Boemeh, n.d.). Mergers and acquisitions also reduce financing costs, stemming from economies of scale when issuing debt and equity securities, as well as from the merged firm's improved access to capital markets at a reduced cost (Boemeh, n.d.).

Although much of the literature on acquisitions focuses on the benefits derived from strategic acquisitions through synergistic advantages, acquisitions can also be financial in nature. Strategic acquisitions are initiated by firms within the same industry or related industries, with the acquirer gaining significant benefits. Financial acquisitions, on the other hand, involve organizations in unrelated industries, where the only benefits are earnings and appreciated value accruing to the acquirer. The major sources of financial acquisitions are conglomerates and private equity firms. The period from 2005 to 2007 saw private equity firms gain $1.6 trillion from acquisitions (Kolker, 2010).