From the outset, however, China experts always believed that HSBC was the government's first choice, with Merrill's name starting to circulate in earnest over the past couple of weeks. For HSBC, the mandate delivers the bank its first major PRC restructuring role and the prospect of leading its first pure PRC equity offering since Jiangsu Expressway back in the mid-1990's.
Winning the mandate also marks an opening shot across the bows of the more deeply entrenched US investment banks as HSBC steps up its ambitions on the Mainland. It is also likely to be viewed as a coup for the bank's newly installed head of China investment banking, Dr Huan Guocang. The well-connected doctor and his team were poached from Salomon Smith Barney earlier in the summer.
The challenge now for both HSBC and Merrill's, as well as domestic financial advisor Citic Securities, will be to transform non-fee paying M&A into a fee-paying equity issue. Eventually, it is expected that the Air China group will be listed in Hong Kong and New York. This will probably not take place for at least another year, however and it is also not yet completely clear whether the group will seek a new listing, or obtain a backdoor listing through CNAC (China National Aviation Corp).
In April, the Chinese government unveiled a long-awaited restructuring plan for the domestic aviation industry. In essence, it decided to create three major groups with hubs in Beijing (Air China), Shanghai (China Eastern) and Guangzhou (China Southern).
The Beijing-based group is to be modeled on Air China and will also incorporate Chengdu-based China South West and CNAC, whose Hong Kong-listed offshoot operates as a passive investment holding company for stakes in Dragonair (43%), Air Macau and Zhejiang Airlines. With assets of Rmb56.05 billion ($6.77 billion), the Air China group should represent the largest of the three, although it is projected to have less planes (118) and less routes (339) than either China Eastern or Southern.
China Eastern, meanwhile has been grouped with China Northwest and the popular Yunnan Airlines, while China Southern has been aligned with China Northern Airlines and Xinjiang Airlines. Between them, the three groups will account for about 80% of the domestic market.
Because Air China has never been profitable, observers say that it will probably have to seek a reverse takeover through the existing Red Chip vehicle. As the injection of much larger assets will be deemed a 'substantial acquisition' by the Hong Kong Stock Exchange, the potential equity offering will, therefore, be subject to a full listing hearing.
Like China Mobile and Unicom before it, Air China will also need to get special dispensation in order to acquire the assets from its Mainland parent. "Under the government's foreign ownership rules, overseas companies can only acquire up to 35% of a state-owned asset in the aviation sector," says one expert. "But these rules are not laws as such, but State Council ordinances, which can easily be waived."
In terms of their prognosis for the growth potential of the Chinese airline industry, analysts say that over the short-term, the three carriers' domestic focus will better insulate them from the current downturn. Over the longer-term, analysts also believe the sector will continue to benefit from surging passenger volumes.
Says Deutsche Bank analyst Kevin O' Connor, "A lot of people concentrate on the fact that the domestic airlines should be badly hit by rising oil prices, because they have to buy fuel at higher than average prices from a state monopoly. But this can be a bit of a misnomer. Every 1% increase in passengers offsets a 10% rise in fuel prices.
"And in China," he adds, "the airlines have been seeing passenger growth increase by more than 10% per annum. There has been much faster growth than the developed world, where typically airlines add passengers at anything from 0.5% to 3% above a particular country's GDP growth level. The million dollar question for China, is just how long can it keep outperforming, before it falls back to more normal growth levels?"
