15th Jan 2008
by Chi-Chu Tschang
The top mainland carrier seems to have trumped Singapore Airlines in the battle for China Eastern and its crucial Shanghai hub
In China's fiercely competitive aviation market, projected to expand almost fivefold by 2026, state-owned Air China has been working hard to shed its second-class image. It has managed to become the country's most profitable airline, booking a $300 million profit on $2 billion in revenues in the third quarter of 2007, and is now allied with one of the world's most admired airlines, thanks to a June, 2006, injection of $530 million from Hong Kong's Cathay Pacific Airways, which owns 20%. Beijing-based Air China, which raised $1.1 billion in a dual listing in Hong Kong and London in December, 2004, now has a market capitalization of $37.4 billion, higher than that of British Airways (BAB), Southwest Airlines (LUV), and Singapore Airlines combined.
There's one big missing piece, though: Air China has just a minimal presence in Shanghai, the country's busiest airport in terms of capacity and on track to overtake Hong Kong as the biggest aviation hub in Asia within the next decade. For Air China to expand in the more profitable international routes to and from China, it needs to be in Shanghai, which along with Beijing is China's only hub for international flights. Without a strong Shanghai operation, Air China's dream of becoming a major player in the global aviation market will remain just a dream.
So after Singapore Airlines and Singapore government-backed Temasek Holdings agreed in September to acquire 24% of Shanghai-based China Eastern Airlines (CEA) for $1.4 billion, rumors started flying that Air China would block the proposed deal (BusinessWeek, 9/25/07). Getting such a big piece of China Eastern would give the Singaporeans the right to prevent future shareholders from controlling the money-losing Shanghai carrier. That would wipe out any chance of Air China's filling its Shanghai hole by acquiring China Eastern down the road.
Investors Cheer Market Victory
Sure enough, two days before China Eastern's shareholders were scheduled to vote on Singapore Airlines and Temasek's proposal to buy 24% of the airline, Air China made a preliminary counteroffer that was more than 30% higher than that of the Singaporeans. That did the trick, and on Jan. 8 China Eastern's shareholders rebuffed the Singaporeans' offer. Air China will now make a formal offer to buy up to 30% of China Eastern by Jan. 22, and analysts are cheering. "This is potentially such an important turning point for Chinese aviation overall," says Peter Harbison, executive chairman of the Center for Asia Pacific Aviation, a Sydney-based consultancy. "Market forces have been allowed to determine the outcome."
And there's still plenty of deal-making ahead for an industry that is much in need of consolidation. China has 22 airlines and the industry suffers from too much competition. The carriers may fly 210 million passengers in 2008, compared with an expected 185 million last year, the General Administration of Civil Aviation said on its Web site on Jan. 14. However while the number of Chinese traveling by air has grown almost 9% annually over the past few years, the Big Three airlines—Air China, China Eastern, and China Southern (ZNH)—are filling less than three-quarters of their seats with paying passengers. Six privately owned budget airlines have popped up in China over the past five years. Consequently, there are too many airplanes going after not enough passengers.
That has led to heated competition on price. While Beijing continues to set the benchmark plane ticket rates, Chinese airlines have been engaged in a price war, discounting ticket prices by as much as 70%. Some airlines have already started to consolidate to pool their resources and cut costs. Last Nov. 30, Hainan Airlines merged with three other airlines to form the country's fourth-largest airline, Grand China Airlines. George Soros invested $25 million in Grand China Airlines in 2006, the same amount he invested in Hainan Airlines in 1995, for a 18.64% stake in the restructured airline, which is planning a Hong Kong share sale. "This round of consolidation is not going to be blocked by the concerns of monopoly because it is actually an over-competition sector," says Ally Ma, a Hong Kong-based aviation analyst with Citigroup C.
Regulators Powerless to Stop Shakeout
China's aviation officials aren't sure what to do. Compared with the first round of consolidation, when the industry regulator forced 10 airlines to merge into Air China, China Eastern, and China Southern in 2000, authorities have been visibly ambivalent about the battle for China Eastern. In October, then-aviation chief Yang Yuanyuan was quoted by Xinhua News Agency saying he personally disapproved of further consolidation but added that he would not block a merger. He said: "If China were to have only one airline, with one fixed ticket price, it won't be good news for Chinese consumers."
However even if regulators object to deal-making among China's airlines they may be powerless to stop it. Since the last round of consolidation China's Big Three have listed in Hong Kong and Shanghai, depriving authorities of the power to ram through drastic changes. "The leaders have no way of making these decisions. They can only offer suggestions. In the end, it's now up to the shareholders to decide," says Xu Jianxin, dean of Civil Aviation University of China's School of Aeronautical Engineering.
Indeed, there are signs that at least some officials want a shakeout. Li Jiaxiang, who was the chairman of China National Aviation Corp. until he replaced Yang as acting minister of China's General Administration of Civil Aviation in December, has proposed turning Air China into a supercarrier to compete with the world's largest airlines outside China. Last August, Air China President Cai Jianjiang told reporters in Hong Kong that Air China would not exclude the possibility of a merger with China Southern.
China Eastern's Grandfather Clause
However, China Southern was never really Air China's target because 90% of the Guangzhou-based airline flights are domestic, while Hong Kong serves as the international aviation hub for southern China. Analysts say that Cai's remarks about China Southern were just a diversion to draw attention away from the fact that he was quietly building up a 12.07% stake in China Eastern, which has a monopoly of international routes into Shanghai through a grandfather clause. If Air China and China Eastern, which are both in the world's top 20 in regard to size, were to merge, they would form the world's fifth-largest airline overnight.
China Eastern is a curious prize. The poorly managed, Shanghai-based airline hasn't made a profit since 2003 and has been teetering on the edge of bankruptcy. Singapore Airlines was apparently willing to overlook these flaws and become China Eastern's strategic partner in exchange for a foothold in China's booming aviation market. China Eastern's share prices in Hong Kong, Shanghai, and New York had been lifeless until speculation that it might be acquired sent it doubling since September.
Now, though, Air China appears poised to claim China Eastern, even if the Shanghai carrier is brought into the fold kicking and screaming. With the shareholder vote, China Eastern lost out on a badly needed capital injection from a foreign investor, which would have saved the airline from bankruptcy. As a foreign investor, the Singaporeans could only take a minority stake in China Eastern as well as three seats on the board of directors, limiting their influence on the management of airline. But if Air China succeeds in taking over China Eastern, Air China could swallow up the less profitable airline and spit out its current management. "We will never consider Air China as a strategic investor," China Eastern Chairman Li Fenghua told reporters after the Jan. 8 shareholder meeting.
Even if China Eastern can't prevent a hostile takeover by Air China, management can try to postpone it for as long as possible. In China Eastern's agreement with Singapore Airlines, there's a lockup clause that prevents the Chinese airline from accepting an offer from competitors until Aug. 9. Air China has tried to assuage China Eastern's concerns by suggesting a share swap, which would allow China Eastern to keep its management independent.
http://www.businessweek.com/globalbiz/content/jan2008/gb20080115_047346_page_2.htm
