The deal signed with China Eastern Airlines in mid-November gave 15.3% of the company to Singapore Airlines and 8.3% to Temasek Holdings, the Singapore investment company. Nevertheless, the agreement is subject to a two-thirds minority approval by both holders of China EasternÆs Shanghai-listed A-shares as well as H-share investors at an EGM on January 8.
An attempt by Air China and Cathay Pacific to derail the deal in mid-September triggered a speculative frenzy in ChinaÆs airline shares, with stocks in Air China surging 35%, China Eastern 47% and those of China Southern Airlines 26%.
But the shares lost about half these gains when Cathay and China National Aviation Holding (CNAHC), the state-run parent of CathayÆs partner Air China, abandoned their planned joint offer for shares in Shanghai-based China Eastern Airlines. The bid was an attempt to establish a grip on Shanghai, which after Beijing is ChinaÆs most lucrative aviation hub, while at the same time thwarting efforts by Singapore Airlines to get a foothold in the market. It surprised observers since the Singapore Airlines deal had been approved by ChinaÆs state council and China EasternÆs board.
Citi analyst Ally Ma believes that Air China will counter-bid and stands a good chance of blocking the deal if it votes against the deal. Air ChinaÆs parent CNAC and four other investment institutions hold 31% of CEAÆs H-share minority shareholdings and 25% of the A-share minorities. These shareholders are unlikely to be pleased with receiving HK$3.80 ($0.49) a share, the price at which the deal with SIA was agreed in September before the Air China/Cathay bid came in, which is a 50.6% discount to China EasternÆs closing price of HK$7.69 on November 2, the last trading day before the stock was suspended prior to a formal announcement of the deal.
Analysts are concerned the deal will not create as many synergies between China Eastern and SIA as there are between Air China and Cathay, as there is relatively little overlap between the networks of the two airlines.
ôIt makes a lot of sense for Air China and China Eastern to consolidate their international legs to compete with foreign carriers, and to build a size-equivalent rival to China Southern in the domestic market,ö says Ma.
Despite how the respective shareholdings stack-up, politics will play a decisive role in the outcome. The deal has received the blessing of the state council, but Li Rongrong, head of the State-Owned Assets Supervision and Administration Commission, was recently reported as saying, "Airline mergers are company moves, not government moves. I just want them to report more profit."
ChinaÆs airline industry is under strong pressure to improve its performance so as to compete with international carriers when the country accelerates the opening of its skies after 2009. Consolidation is one solution along with linking up with a strong international partner.
ôThere is a desire for consolidation to make ChinaÆs airlines stronger and better able to compete at an international level. But the situation is very unclear û there are a lot of politics involved,ö says Adrian Lowe, airline analyst at stockbroker CLSA in Hong Kong.
The industry has benefited from ChinaÆs stellar economy, which for the past four years has grown by at least 10%. Boeing is forecasting average annual revenue per passenger kilometre growth of 7.9% for the next 20 years for the countryÆs combined domestic and international air traffic growth.
In addition the industry is also getting a boost from the 2008 Olympic Games, which analysts say will increase Beijing air traffic by as much as 20-25% in that year and by about 15% in 2007 due to pre-Olympic activity. The increase in capacity by both Chinese and international carriers is putting downward pressure on fares and yields.
Despite several restructuring efforts û the last in 2002 û two out of ChinaÆs big three airlines are still struggling. In 2002, the Civil Aviation Administration of China (CAAC) reorganised the nine airlines it controlled into three: Air China, China Eastern and China Southern. Since then performance has been mixed due in part to the nature of the reorganisation û some airlines inherited old aircraft, airports that were expensive to run and incompatible airline networks. But much has been due to poor management.
The decision to introduce foreign carriers such as Cathay and Singapore Airlines is recognition by the authorities that more aggressive action is needed to get the mainland carriers into shape. Foreign airlines can acquire up to 49% of a domestic airline, but an individual foreign airline can own no more than 25%.
Although all of the main three airlines are now listed, they are hampered in their efforts to strengthen their finances by the Chinese government, which still controls virtually everything they do. According to analysts, orders are still placed in bulk with manufacturers on behalf of the airlines by the Chinese government. But control also extends to senior managerial appointments, fare levels, route choices and most major operational decisions. On fares, for example, the government sets the overall fare level and airlines are only allowed to vary prices in a band up to 25% above and 45% below.
China Eastern is by far the weakest of the three major airlines. It has lost Rmb4.5 billion ($605.4 million) during the previous three years. In the first half of 2007 China SouthernÆs revenue rose by 19% and net profits reached $22 million, compared with a $108 million loss during the first half of 2006.
Air China on the other hand has been profitable for the past five years, earning a total of Rmb8.6 billion between 2002 and 2006.
After apparently abandoning, at least for the moment, the bid for China Eastern in September, Air ChinaÆs president told news reporters that he did not rule out a tie-up with China Southern or other domestic airlines. He also mentioned other potential merger targets such as Hainan Airlines and Shanghai Airlines, respectively ChinaÆs fourth and fifth largest airlines. But speculation largely has centred on China Southern as the next likely target for a strong partner, because it is the only one of the big three airlines not to be linked with a foreign partner.
A tie-up with Air China would make sense strategically, giving the flag carrier access to a huge domestic network and giving China Southern a large international route network. But whether Air China is the right partner is arguable since the airline needs support from a partner that can provide operational expertise as well as financial support. This suggests a foreign partner but the question is which one would be acceptable to the Chinese leadership. The only foreign airlines so far countenanced by China have been Cathay and Singapore Airlines. Both are arguably Asian airlines and senior executives can speak Mandarin. They are also far and away AsiaÆs strongest airlines.
ôCathay has its hands full with its present arrangement with Air China and Singapore Airlines is linked to China Eastern. There arenÆt really any other airlines with similar characteristics,ö says CSLAÆs Lowe.
China Southern recently joined the Sky Team airline alliance, which includes Air France-KLM and Korean Air. There has been speculation surrounding a merger with Air France. The two have held talks over code-share connections for routes in China and also about entering a cargo joint venture agreement but it is not clear that Air France-KLM would be viewed as an acceptable partner.
This lack of suitable partners has fuelled speculation that the big three airlines could be reduced to two. Analysts even say there has been industry talk of a single mega airline. But CACC Director-General Yang Yuanyuan said recently that although it was the airlinesÆ decision, he personally felt it was too early too reshuffle the top three carriers as this would stifle competition. He further added that none of the three had the capability of managing the resultant huge airline.
Acquiring or merging with Shanghai Airlines presents an interesting option for Air China and would give it a market share of the Shanghai air traffic of around 30%, compared with China EasternÆs current market share of about 30%. Shanghai Airlines posted a net profit of $10.3 million for the third quarter of 2007, up 7.3% year-on-year. Air China is due to join the Star Alliance later this year as will Shanghai Airlines, further heightening merger speculation. Plus, Air China is planning to strengthen its Shanghai base during the next year according to analysts. But Shanghai Airlines has also been linked with China Eastern. Air China has also been linked with Shenzhen Airlines, ChinaÆs sixth largest airline. It earns much of its revenue through a cargo joint venture with Lufthansa and is well regarded by the industry.
As Martin Craigs, president of the Aerospace Forum Asia put it: ôItÆs an ongoing situation where the dynamics are always going to be changing.ö
A version of this story first appeared in the November issue of FinanceAsia magazine.
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