Economic uncertainty blows the airline industry off course

When you think of the credit crunch you naturally think of the banking crisis.  The UK government has spent a colossal £1.5 trillion to date bailing out its banks since 2008.  To put this into perspective; in the UK £500bn was spent on the banking rescue plan in the year following the 2008 crisis compared to a measly £193bn spent on health and education.  Credit crunch is a term used to describe “a severe shortage of money or credit” and this is certainly not a problem that is confined to the banking sector alone.

The financial crisis meant banks were much less inclined to lend to their customers and the cost of borrowing increased dramatically.  House prices and share prices also plummeted.  The upshot of this for everyday people is a severe impact on market confidence and a reduction in their disposable incomes.  People who have less money to spend are forced to focus their income on essential spending rather than luxury goods.  The impact of this on many businesses has been monumental.  This is the point at which a crisis confined to the banking industry becomes a wider social issue, the consequences of which continue to be felt today.

The airline industry is clearly feeling the effects.  Cathay Pacific, a Hong Kong based worldwide airline, this week announced a dramatic fall in profits.  The airline made only 5.5bn Hong Kong dollars in 2011 in comparison to 14bn the previous year; a decrease of 61%.  Although rising fuel costs and unexpected weather conditions were drivers behind the drop in profits the principal reason provided by Cathay Pacific was “global economic uncertainty” which had hit passenger numbers.  The problem is that in a recessionary climate everyday people are less likely to spend what little money they do have on travel. The problem is not confined to Cathay Pacific alone; their announcement follows similar tales of woe from Air France-KLM, Malaysia Airlines, Air Berlin and Air Asia in the last month.  The problem is clearly a worldwide one and one that is probably here to stay.

Economic confidence is at an all-time low especially in Europe where the on-going Euro crisis is damaging people’s disposable income and will limit spending, on non essential items such as flights for the foreseeable future.  Widespread unemployment and in particular youth unemployment adds to the problem.  Young people are a significant part of that sector that spends their money on flights in order to go on holidays around the world.  When you throw these confidence damaging issues together the prospects for the airline industry and the wider business world don’t look good.

The early signals are that the airlines themselves don’t expect the situation to improve.  Ryanair, KLM and Qantas have all recently announced they are to cut staff in response to declining passenger numbers.  But this is symptomatic of the underlying problems  I believe lie ahead for the worldwide economy as a whole; people have less money to spend, so they spend less, so businesses profits fall,  in response they cut staff numbers, so more people are out of work with less money to spend.  And so the dangerous cycle continues. When a similar situation arose in America in the 1930’s after the Wall Street Crash, President Roosevelt increased government spending on a range of measures including building new schools, roads, dams and agricultural regeneration schemes such as the Tennessee Valley Authority to kick start the economy and get people back to work. Even then his measures only reduced unemployment by approximately 50%. A return to full employment in Europe and the USA only came after the start of World War 2 with its subsequent demands on manpower and war materials.

The roots of today’s problems lie with the financial crisis. The result has been significant damage to people’s ability and willingness to spend. Businesses of all kinds will continue to pay the price.



RBS acquisition of ABN Amro: bad decision, bad timing or the Fred effect?

In October 2007 the Royal Bank of Scotland Group (RBS) led a consortium in acquiring Dutch bank ABN Amro in a deal worth £50bn.  However, a year later the company had endured a £5.9bn write-down of its asset book value, a £12bn rights issue to raise necessary capital and eventually had to be supported by HM Treasury in a well-publicised bail out of UK banks.  The question is; what went wrong?

First of all the motivations for the acquisition have to be seriously called into question.  The £50bn deal represented a hefty chunk of capital but this seems even pricier when you consider that RBS paid a whopping 70% premium over the actual value of ABN Amros’ shares.  This was evidently a boom time in the banking industry and sacrifices have to be made, many argued.  During mergers and acquisitions companies usually expect to pay a 20-30% premium on the value of the target companies shares but looking back, boom or no boom, this price seems ridiculous.  In addition there was growing uncertainty in capital markets and it was being questioned whether growth could be sustained in the banking sector.

Nevertheless the acquisition promised to provide RBS with €1.8bn synergy gains and would enhance the group’s international capabilities.  What part did management play in the failures of this takeover?

RBS’ acquisition of ABN Amro was a hostile break up bid and it was virtually unprecedented to break up a company which operated on such a worldwide stage, in particular a bank.  Since 2000 ABN Amro had experienced rapid expansion into the foreign markets of Europe, South America and the USA.  At one point it had been seen as a potential rival to some of the banking sector’s leading world players.  However the company had experienced recent poor performance leading to deterioration in the share price and calls from its own shareholders for the company to be broken up.  Considering the growing concerns over the viability of the banking sector surely RBS would have been best served by refining and improving the existing services of the bank.  ABN Amro quite obviously had the ability to be successful, they just needed the guidance of RBS to realise this once again.

However RBS were fully intent on a major overhaul of the business involving extensive staff cutting and cost saving measures.  This was represented early on by the dismissal of ABN Amro’s current CEO Rijkman Groenink for a costly final severance package of just over €30m.  This, and other strategic decisions, was questionable, however RBS quite clearly wanted to firmly plant their own stamp on affairs.  Commentators at the time drew distinct similarities with RBS’ extremely successful takeover and implementation of the National Westminster (Natwest) bank in 2000.  RBS were quite fairly attempting to follow a similar process.  But what went wrong this time around?

Firstly, and most importantly, post deal there was a serious decline in credit market conditions and a quickly worsening economic outlook in what has since been coined the ‘financial crisis’.  For RBS this meant the capital required to fund the ABN Amro deal was placing a huge strain on the company’s assets.  This, coupled with the exposure to the housing market crash, led to the write down of £5.9bn of the company’s assets and a £12bn rights issue in April 2008 to help shore up the company’s finances.   At the time this represented the largest rights issue in UK corporate history and the deal allowed shareholders to purchase shares at an incredible 46% discounted price of only 200p per share (the actual share price at the time was 372.5p!).  The turmoil was quite clear to see and the capital straining ABN Amro deal was being pinpointed as the root of the problems.

The situation did not ease and the UK government famously intervened in October 2008 to help recapitalise UK banks.  RBS was one of the main beneficiaries of an initial £37bn bailout aimed at stabilising the situation; providing short term liquidity and facilitating future lending.  What I cannot understand is if there was uncertainty surrounding the UK economy, and in particular the banking sector, then why participate in such a daring, capital intensive takeover of ABN Amro.  Perhaps the motives of a certain individual could help explain this?

The acquisition of ABN Amro represents the world’s biggest ever bank takeover and the then CEO, Fred Goodwin, would have taken immense personal pride in being at the centre of such a prestigious deal.  John Varley, CEO of rival bidder Barclays, commented at the time that Goodwin was willing to pay any price for ABN Amro - to win at any cost!  Goodwin appeared to take the attitude that he had done it before with Natwest, why couldn’t he do it all over again.  His overriding desire was to enhance the bank’s worldwide power as opposed to protecting the welfare of the company and, in particular, the shareholders.  In the year from the takeover to the government bailout RBS shareholders lost an astonishing 440.5p (86%) off the value of their shares - and the situation is still no better:

The ABN Amro acquisition was an immense failure, but it could be argued this was largely due to it being a victim of circumstances.  The credit crisis put too large a strain on RBS resources and ultimately the ABN Amro deal went down with it.  But the cost of the deal reached dizzy heights at a time of uncertainty and I would describe it as a silly deal at the end of a simmering debt-fuelled boom in the UK economy. A bank like RBS, the epitome of safety to many, should have known better and Goodwin not only should but probably did know better.

Volkswagen leads the way in the FDI decision race

Foreign Direct Investment (FDI) is ‘The purchase of physical assets or a significant amount of ownership of a company in another country to gain a measure of management control’ (Wild, Wild & Han, 2004).  There are commonly two types of FDI which can be categorised as Greenfield investment or International mergers and acquisitions activity.  Greenfield investment is when a company solely enters a market and invests in offices, buildings or other physical assets.  Conversely International mergers and acquisitions is when a company joins forces with an international business or businesses.

FDI has been the biggest flow of resources into developing countries in the last 20 years.  Much of this has been driven by the growth in international technology advancements and the desire of large domestic companies to make the step to become multinational.  It could be argued we are part of a ‘multinational era’ where almost all large firms have operations all around the world which originated from significant FDI.  In recent years the most rapidly increasing inflow area for FDI has been south-east Asia.  But why do firms decide to employ FDI in the first place?

·         Market – firms may be facing domestic saturation or could see an international market as a growing source of demand.

·         Raw materials – international regions may have high levels of natural resources that are essential to a firms output and hence it makes sense to get closer to them.

·         Product efficiency – a business may employ FDI to make their business more efficient.  This could be by seeking technology or, more commonly, lower labour costs.

·         Knowledge – it may be that international countries have specific knowledge bases that could be exploited to aid the growth of a business.

The reasons outlined to explain FDI are generic principals often outlined in academic texts.  In reality the reason depends entirely on the motive of the firm in question.  For example fast food chain McDonald’s expansion into the Asian market in the late 70’s and 80’s was largely driven by the rapidly expanding market for fast food in the region.  Conversely UK and US service sector industries often locate their call centres in countries like India and the Philippines to take advantage primarily of the cheap labour force that is available.  However I would expect that within any motivation the overriding desire is to maximise growth and ultimately increase profits.

German company Volkswagen is the world’s second largest motor vehicle manufacturer and the biggest in Europe.  The group also owns well know automobile companies Audi, Seat and Skoda.  In 2011 the company’s profits more than doubled to €15.8bn as they delivered a record 8.2 million vehicles.  These impressive figures have been underpinned by their strong performance in the three biggest growth areas; China, Brazil and India.  Volkswagen is popular in these areas, and all around the world, due to their flexible strategy; they make cars to fit local tastes and needs and price the vehicles to suit the finances in the market place.  For example in China Volkswagen focus on small vehicles like the Polo to suit the busy roads and have been known to lower their prices to make them more available to the masses that have little disposable income.  But these cars are no longer being imported from factories in Germany; the growth has been supported by notable spurts of FDI.

Volkswagen targeted China over a quarter of a century ago with a joint venture in 1984, the Shanghai Volkswagen Automotive Company Ltd.  This was shortly followed by the Volkswagen Automotive Company Ltd in Changchun in 1990.  This was seen as incredibly risky by analysts as China was still in the throes of a cultural and economic revolution at the time and uncertainty still clouded the region.

China is now, and has been since 2008, the largest car producer in the world.  In 1990 China produced less than a million vehicles a year but now produces over 20 million annually.  Over 50% of this production is undertaken by foreign companies of which Volkswagen is the largest.  Volkswagen’s Chinese subsidiaries are now wholly independent of their German roots and control the entire value chain; from design and production right through to sales and service.  This is an example of an incredibly successful piece of FDI with the company taking advantage of a fast growing consumer market coupled with the country’s low cost labour and now highly advanced infrastructure.  What makes this all the more impressive is that the world’s leading motor vehicle manufacturer, General Motors, did not invest in China until as late as 1997 in a joint venture with Shanghai Motors.  This highlights Volkswagen’s notable foresight in investing so early and gaining a firm footing in the market before its main competitors.

However in December 2011 a joint announcement by the Ministry of Commerce and the National Reform and Development Commission in China stated it would ‘withdraw support for foreign investment in the country's car industry to encourage domestic carmakers’.  This is a fair decision in a struggling world economy as the government simply wants to support domestic businesses by stimulating local production.  But where does this leave Volkswagen? If they want to continue their worldwide expansion surely they will have to find somewhere new in which to invest?

The answer is that they already have - India.  Volkswagen has invested €580m in India since 2006; Volkswagen India Private Limited has a large production facility in the northern state of Punjab which produces 110,000 units annually.

India is currently the second fastest growing motor vehicle market and is likely to become the fastest growing in the next 20 years.  It is expected that domestic demand will outstrip that of the USA by 2035 and China by 2050.  Volkswagen sales in India were up 18% in 2011 and the head of the passenger car division of Volkswagen India, Neeraj Garg, told the BBC that he ‘expected the same compounded interest over the next four to five years’.  All in all this makes it an essential market to have an influence in.

Volkswagen has displayed their investment foresight once again and has taken advantage of the significant benefits of FDI in India.  Firstly, as discussed, it is a rapidly expanding market and it seems logical for cars destined for India to be produced within the country.  Also India has a vast, knowledgeable workforce which remains cheap to employ.  In the past the poor infrastructure in India has limited the extent of FDI flowing into the country.  However as the economy expands, currently the second fastest growing economy after China, the infrastructure is rapidly improving.  As time progresses more and more manufacturing and production companies will look to invest in India.

In the case of Volkswagen it looks like they have implemented FDI with seemingly perfect timing.  They entered China before the boom and then expanded abroad, to India, as the Chinese market seems to have reached saturation point and the Indian market is in the infancy of what is expected to be a rapid development.  Whatever the future holds for the car manufacturing industry it appears Volkswagen will be at the forefront.  Whether the next boom area is Russia, Brazil, Africa or somewhere different altogether it is likely Volkswagen will already be there ready and waiting.